Legacy Pensions Face Unintended Tax Consequences

The opinions expressed within this article are solely the author's and do not reflect the opinions and beliefs of the Actuaries Institute or its affiliates. The information in this article is for general information only. It should not be taken as constituting financial advice.

As the dust settles on the new regulations introduced from 7 December 2024, a significant technical challenge is emerging for advisers and SMSF trustees concerning the proposed Division 296 tax measure, especially where members hold complying income streams, such as lifetime or life-expectancy pensions, within their SMSFs.

With many trustees considering commuting their legacy pensions under the new regulations, this magnifies the importance of understanding how these legacy pensions are treated for total superannuation balance (TSB) purposes in the Division 296 calculations.

The core issue: Artificial inflation of Division 296 earnings

With the new regulations making the commutation of legacy income streams more accessible from 7 December 2024, there’s a critical concern with the initial drafting of the formulas for calculating Division 296 tax. 

The difference in the TSB valuation of a complying pension at 30 June preceding an income year and at the end of the following income year, where the pension is commuted in that income year, can increase a member’s TSB due to the allocation of the pension reserve to the member upon commutation. This, in turn, can inflate ‘earnings’ for Division 296 purposes as the drafted rules specified that only allocations from a reserve that were assessed as a concessional contribution would be excluded from earnings.

Consider this scenario:

• As of 30 June 2025, an SMSF has one male member, aged 70, with a non-reversionary, non-indexed lifetime pension (Transfer Balance Account or TBA special value: $1.6 million), reserves backing the pension liability ($2 million), and an accumulation balance of $2 million.
• For Division 296, the calculation as of 30 June 2025 is $2 million (accumulation) + $1.09 million (family law value for the lifetime pension, based on the prescribed factors) = a TSB of $3.09 million.
• A year later, for simplicity, assume $100,000 was withdrawn via a pension payment and there were no investment earnings on the accumulation balance. The TSB of 30 June 2026 would be $2 million (accumulation) + $1.06 million (family law value for the lifetime pension) = $3.06 million. Adjusted TSB is $3.06 million + $100,000 (add back the pension payment) = $3.16 million. Division 296 earnings are then calculated as $3.16 million - $3.09 million = $0.07 million. The exact numbers work out to $69,000 in Division 296 earnings.

The numbers change dramatically if the member commutes their pension in 2025-26, taking advantage of the new legacy pension commutation rules:

• The lifetime pension is commuted in full, and the $2 million reserve is transferred to the member’s accumulation balance. The member receives a TBA debit for $1.6 million. The member decides to start a new account-based pension (ABP) with $1.6 million, the maximum allowed under their personal transfer balance cap, and leaves $400,000 in the accumulation phase. For consistency, let’s assume they take a $100,000 pension payment prior to 30 June 2026, making the 30 June balance $1.5 million.
• At 30 June 2025, their TSB remains $3.09 million as calculated previously.
•  At 30 June 2026, their TSB is now $2.4 million (accumulation) + $1.5 million (ABP) = TSB of $3.9 million.
• The adjusted TSB is $3.9 million + $0.1 million = $4.0 million, and ‘earnings’ for Division 296 purposes are then calculated as $4.0 million - $3.09 million = a staggering $910,000 compared to $69,000 where the legacy pension is not exited - the artificial inflation in Division 296 earnings is clear.

Why does this happen?

The method for calculating TSB for legacy pensions is not tied to the market value of assets supporting the pension liability. Currently, the TSB for a lifetime pension is generally the original TBA credit (special value) of the pension. This is proposed to change to be based on a valuation using family law factors as part of the introduction of Division 296.

In most cases, both the special value and the family law valuation is lower than the amount being held in reserve to support the pension liability.

However, when the pension is commuted in full and the reserve is allocated to the member’s superannuation interest, this can result in a substantial jump in TSB for the member, driving up Division 296 earnings for that year.

This is likely to occur in any financial year (during the 5-year legacy pension exit period) where a defined benefit pension is commuted, and the monies are retained in superannuation.

In practice, it is not only allocations from a reserve upon commutation that will lead to inflated Division 296 earnings. Any amounts allocated from a reserve to a member, which are not assessed against the member’s concessional contributions cap, won’t be included in ‘contributions’ and so would lead to inflated Division 296 earnings. This would include:

• amounts allocated using the ‘fair and reasonable’ reserve allocation rules
• amounts allocated to a member from a reserve due to the commutation of a complying lifetime, life expectancy pension, or flexi pension
• amounts allocated from a pension reserve to a member who was previously the recipient of a defined benefit pension funded from that reserve

What’s the solution?

The adjusted TSB calculated at year’s end adds back on withdrawals and deducts contributions made during the income year. However, ‘contributions’ do not currently include allocations from a reserve, which are not counted against a member’s concessional contribution cap. This oversight means ‘cap-free’ reserve allocations directly inflate Division 296 earnings in the year of commutation.

The Division 296 legislation was drafted prior to the new regulations for commutation of legacy pensions, and so it is highly likely that the legislation will need to be updated to account for this. For example, reserve allocations that do not meet one of the cap-free exceptions are now assessed against a member’s non-concessional contribution cap and not the concessional contribution cap.

A solution to fix the issue of inflated Division 296 earnings upon commutation of a defined benefit pension could involve amending the Division 296 TSB adjustment rules to include in the definition of ‘contributions’ allocations from a reserve to a member which are not assessed against a contribution cap, less the TSB immediately prior to commutation value of any defined benefit pensions which ceased or were commuted in the year resulting in a reserve allocation.

This would ensure the end-of-year TSB is only reduced by the part of a reserve allocation not already represented in the TSB for the member at the start of the income year.

Continuing the scenario…

Taking the scenario above, where the member commutes their pension in 2025-26, let’s assume this is done on 1 July 2025, taking advantage of the new legacy pension commutation rules:

• At 30 June 2025, their TSB remains $3.09 million.
• At 30 June 2026, their TSB remains $2.4 million (accumulation) + $1.5 million (ABP) = TSB of $3.9 million.
• The year end adjusted TSB is now calculated allowing for the proposed solution above as $3.9 million + $0.1 million pension payment - ($2 million reserve allocation - $1.09 million TSB) = $3.09 million, and ‘earnings’ for Division 296 purposes are then calculated as $3.09 million - $3.09 million = $0 - no earnings, the artificial inflation in Division 296 earnings is removed!

Advisers are seeking urgent clarity

The unintended consequences of the current proposed rules will leave many clients facing an administrative and financial scramble. Members with large balances will be penalised for commuting their legacy pensions and allocating fund reserves, under the five-year exit measure for legacy pensions.  They may incur material Division 296 tax on what is effectively capital of the fund, not earnings.

The Division 296 rules need to be fixed to remove the inflation of ‘earnings’ for clients who commute defined benefit pensions and allocate reserves, and to allow advisers and clients sufficient time to make decisions in light of the new rules. The introduction of Division 296 should be deferred to 1 July 2026.

One thing is clear: the legacy pension rules highlight the need for a more considered approach and, arguably, for deferral of Division 296’s commencement. Time is needed for a legislative framework that deals fairly with the unique nuances of legacy pensions, so trustees and advisers can act with confidence.