Beware the estate planning transfer balance cap

So what is this “estate planning transfer balance cap trap” that can arise from adopting the mirror reversionary pension strategy?

More importantly, is there a way to avoid it?

Well, it all stems from how the Transfer Balance Account works.

Let’s begin with a bit of a refresher:

• As we all know, the Transfer Balance Cap is a limit on the amount you can hold in the superannuation retirement phase (namely $1.6 million in 2017–18, indexed periodically in $100,000 increments in line with the CPI).
• The Transfer Balance Account is a method of tracking transactions and amounts in retirement phase. It measures your Transfer Balance, which is the sum of credits less the sum of debits posted to the account.
• You start to have a Transfer Balance Account on 1 July 2017 if you are already receiving a retirement phase pension at the end of 30 June 2017, or if not then on the day you first start to receive a retirement phase pension.
• The balance of your Transfer Balance Account determines whether you have exceeded your Transfer Balance Cap at the end of any given day – so clearly it’s pretty important to keep a close eye on the balance at any given point in time.

If your transfer balance does exceed your Transfer Balance Cap, you will have an ‘excess transfer balance’. In this event, the Tax Office will calculate your ‘excess transfer balance earnings’ and credit this amount to your Transfer Balance Account. Excess transfer balance earnings accrue on the excess and are credited to your Transfer Balance Account daily.

You will then be liable to pay excess transfer balance tax on those earnings. The rate of excess transfer balance tax is 15% for any excess periods that start in the 2017–18 financial year, then from 1 July 2018 the rate is 15% for a first year breach and then 30% for subsequent breaches. You can transfer the excess to an accumulation account or take it out of super, but you will need to ensure you remove an amount large enough to cover both your excess and your excess transfer balance earnings.

So you can see that Credits to your Transfer Balance Account increase your transfer balance, and thereby reduce your available cap space (bad). On the other hand, Debits to your Transfer Balance Account may reduce your excess transfer balance, and/or increase your available cap space (good).

Okay, so what are counted as Debits and Credits to your Transfer Balance Account?

The most common transfer balance credit arises when you begin receiving a super income stream (or pension) that is in the retirement phase. Credits to your account include:

• the total value of any super interests that support retirement phase pensions you were receiving on 30 June 2017;
• the value of new retirement phase pensions, including super death benefit pensions and deferred super pensions, that you begin to receive on or after 1 July 2017;
• the value of reversionary super pensions at the time you become entitled to them;
• the excess transfer balance earnings that accrue on any excess transfer balance amount you have;
• where a super fund makes a payment towards a limited recourse borrowing arrangement, if the payment increases the value of retirement phase interests.

Your Transfer Balance Account is most commonly debited when you fully or partially commute a retirement phase pension. Importantly, when a super pension is fully or partially commuted, your Transfer Balance Account is debited by the actual amount commuted. It is therefore possible for your Transfer Balance Account to have a negative balance if your debits exceed your credits. So for instance, if you commute a pension where the underlying assets have grown from $1.6m to $1.7m, this will result in a Transfer Balance Account of negative $100,000.

We can now look at what is the “estate planning transfer balance cap trap”. As mentioned earlier, the “current wisdom” amongst many advisers post 1 July 2017 is that client couples should make their superannuation pensions automatically reversionary to each other, so that the survivor of them has a 12 month window of opportunity to re-adjust their superannuation affairs in view of their Transfer Balance Cap at the time. Then, any extra accumulation account balance is typically directed under a Binding Death Benefit Nomination as a tax free lump sum to the spouse.

The objective of this strategy is to maximise what the surviving spouse can retain in the concessionally taxed super environment.

But this strategy can potentially lock the client into a position in which the surviving spouse may actually miss the opportunity to use their deceased spouse’s super to maximise their tax free retirement pension account – perhaps to the tune of hundreds of thousands of dollars or more!

Let’s look at a simple example to illustrate:

• Homer and Marge are married and each has a total super balance of $2.5m.
• They both retire aged 65 years old and each starts an account-based reversionary pension valued at $1.6m on 1 January 2018, leaving $900,000 in accumulation which they each direct to the other as a tax free lump sum via a BDBN.
• Marge’s Transfer Balance Account starts on 1 January 2018 and is credited with $1.6m. So she has no further Transfer Balance Cap space available.
• On 20 September 2018, Homer dies. His reversionary pension (still valued at $1.6m at his date of death) reverts to Marge.
• Marge’s Transfer Balance Account will be credited with $1.6m. However, the credit will not arise in her Transfer Balance Account until 20 September 2019, being 12 months after Homer’s death, thus giving Marge time to plan her financial affairs.
• On 2 June 2019, Marge fully commutes her account-based pension to accumulation, creating a debit of $1.6m in her Transfer Balance Account, so her transfer balance is reduced to zero.
• On 20 September 2019, Marge’s Transfer Balance Account is credited with $1.6m (the value of Homer’s pension at his date of death). Marge’s transfer balance is then brought back up to $1.6m and she has no Transfer Balance Cap space remaining.

So Marge keeps $4.1m (a $1.6m pension plus $2.5m in accumulation) in super. This is a great result.

However, let’s tweak the facts a little:

• Homer and Marge are married and each has a total super balance of $2.5m.
• Both retire aged 65 years old and each starts an account-based pension valued at $1.6m on 1 January 2018, leaving $900,000 in accumulation which they each direct to the other as a tax free lump sum via a BDBN.
• Marge invests her pension capital in Sydney residential real estate, whilst Homer invests his in a diverse portfolio of technology and resources shares.
• On 20 September 2023, Homer dies. His reversionary pension (its value now only $1.2m at his date of death – Do’h!) reverts to Marge.
• Meanwhile the value of Marge’s pension balance has increased to $2m (Woohoo!).
• Marge’s Transfer Balance Account will be credited with $1.2m on 20 September 2024, 12 months after Homer’s death.
• On 2 June 2024, Marge fully commutes her account-based pension to accumulation, creating a debit of $2m in her Transfer Balance Account and resulting in a negative transfer balance of minus $400,000.
• On 20 September 2024, Marge’s Transfer Balance Account is credited with $1.2m (the value of Homer’s pension at his date of death). Marge’s transfer balance is now back up to $800,000 and she still has $800,000 Transfer Balance Cap space remaining.
• But – Marge cannot commute Homer’s $900,000 lump sum death benefit to her back to super, so on 30 October 2024 she decides to start another pension using $800,000 from her own accumulation account (which is then reduced to $2.1m) so she fully utlilises her Transfer Balance Cap space.

So, Marge had to withdraw $800,000 from her own accumulation account to maximise her tax free retirement pension. This represents a lost opportunity.

The estate planning transfer balance cap trap is this – when Homer made a BDBN in relation to his $900,000 accumulation account in favour of Marge as a lump sum, her only option was to accept it coming out of the super environment. There was no opportunity for Marge to take any part of it as a pension so as to utilise her remaining $800,000 Transfer Balance Cap space.

How can you avoid the estate planning transfer balance cap trap?

Let’s go back to our example. Assuming an appropriately worded trust deed (such as a SUPERCentral deed), Homer could have made a tailored BDBN over his accumulation balance in favour of Marge so she could have had the opportunity to use $800,000 of Homer’s accumulation account balance to top up her Transfer Balance Account to the permitted maximum Transfer Balance Cap, utilise her negative account balance, and therefore retain that amount within super, with any remaining excess from Homer’s super then taken by her as a lump sum, or else go into his estate for his Will to direct.

Of course, not everyone will have circumstances as straightforward as Homer’s and Marge’s in the above example, so where a client couple has a significant amount in superannuation (and particularly where either or both of them have already exceeded their Transfer Balance Caps), it is important to have an estate planning specialist review their situation to determine if they are likely to fall into the estate planning transfer balance cap trap and what might be the best way to avoid it.

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By Brian Hor, Special Counsel, Superannuation & Estate Planning