Are Re-Contribution strategies a scheme to avoid tax?

Since the work test was abolished in July 2022, re-contribution strategies have become increasingly popular among older age groups. To use a re-contribution strategy, you must:

• have met a condition of release, such as turning 65 or turning 60 and retired,
• and be eligible to make super contributions.

Before the 2022 change, anyone aged 67 or older couldn’t make non-concessional contributions  unless they were working. Now, SMSF members have a much longer window to take advantage of this strategy. However, from age 75 onward, non-concessional contributions aren’t allowed, and only limited concessional contributions are possible.

Hint – Previously, to pass the work test, a member needed to be gainfully employed for at least 40 hours within 30 days or qualify through a one-off work test exemption.

What is a Re-Contribution Strategy?

It is simply withdrawing a lump sum from your SMSF and recontributing the money back in. Generally, the strategy seeks to maximise the tax-free component of a superannuation income stream or superannuation death benefit paid to a member’s adult children. The strategy can also be used to make a member personal concessional (taxed) contribution subject to the contribution caps, but this strategy is a red flag to the ATO and must be carefully undertaken.

When is a Re-Contribution Strategy a scheme to avoid tax?

Part IVA of the Income Tax Assessment Act 1936 is an anti-avoidance rule that allows the ATO to cancel any tax benefit gained and impose additional penalties depending on how serious the violation is. To breach this rule, there must be a scheme with the dominant purpose of obtaining a tax benefit. The ATO focuses on identifying artificial arrangements rather than simply using legitimate concessions.

Re-contributing a non-concessional to start a new pension

The ATO have stated that simply withdrawing a lump sum payment and re-contributing the same amount as a non-concessional (tax free) contribution soon after with the purpose of commencing an income stream will unlikely be tax-avoidance. This is because the main goal is usually to optimise available tax concessions for estate planning, particularly if the SMSF member has adult children. While the ATO recognises that there could be some tax benefits involved, they also note there is no guarantee the member’s super balance won’t be exhausted before the member’s death or paid to a surviving spouse instead.

Re-contribution strategy when death is imminent

Using a re-contribution strategy when a member’s death is imminent may appear contrived to the ATO potentially triggering Part IVA. When death is likely to be in the next week it is not absolutely certain but objectively it would be difficult to argue the dominant purpose was not to avoid tax.

Withdrawal of a lump sum and contributing a member concessional (taxable) contribution

A strategy where a lump sum withdrawal and a personal concessional contribution were made for the same amount on the same day would be a red flag to the ATO. It would be difficult to justify any reason for this other than seeking a personal tax deduction.

Alternatively, if a member has a consistent history of making concessional contributions and claiming a personal tax deduction, then makes a personal concessional contribution in the year they retire – prior to withdrawing part of their super balance – the ATO will likely accept this. However, the “intent to claim a tax deduction” must be submitted to the fund trustee before withdrawing the lump sum, and the arrangement cannot appear to be contrived.

How does this work?

Let’s start with what the underlying tax components are which make up your SMSF member balance. There are generally two components being tax free and taxable.  There is a third component being untaxed which is relatively rare in an SMSF and we are not covering this.

Tax free components are generally the contributions made to your fund from:

• after tax earnings (i.e. wages you have earned and already paid tax on)
• downsizer contributions up to $300,000 (technically not a contribution but is part of the underlying tax-free component) for eligible member’s aged 55 or over when they sell their principal residence
• small business CGT exempt contributions on the disposal of an eligible business

The taxed component generally represents:

• employer contributions
• salary sacrifice contributions
• personal contributions where you have claimed a tax deduction
• earnings

The proportioning rule states that when you withdraw a lump sum, it is divided between the tax-free and taxable portions. Tax applies only to the taxable part. For example, if you take out $100,000 and 10% is tax-free while 90% is taxable, then $90,000 will be taxed. The exact amount of tax liability depends on several factors, including your age and whether the beneficiary of a lump sum death benefit is an adult child or a surviving spouse. The tax-free component remains tax free in the hands of the SMSF member or death benefit beneficiary.

Recontribution of the lump sum can be made as a tax-free non concessional contribution provided you are eligible to contribute it to your SMSF.

Rebalancing the tax components of a member’s super balance occurs when a lump sum is withdrawn and then re-contributed as a tax-free amount, increasing the overall tax-free portion. There are several methods available to maximise this tax-free portion. Commonly, this involves starting a pension from the member’s accumulation account, making a tax-free contribution, and then commencing another pension effectively quarantining the earnings and the contribution as 100% tax-free.

What benefit does a Re-Contribution Strategy give me?

A re-contribution strategy does not benefit you but can benefit your adult children in the future and therefore is an important part of your estate planning. The strategy allows you to re-balance your underlying tax components to increase the tax-free amount. Adult children, who are not financially dependent on their parents, are taxed on the super money they inherit at 15% (plus Medicare unless it is paid from the member’s estate) on the underlying tax component.  The tax-free component which flows through is not taxed in the child’s hands.

Examples 1 and 2 involved similar death benefit payments to adult children, but in example 2 the beneficiary saved $36,000 in tax. While the ATO may view example 2 as tax avoidance, there is a strong argument that Bob could not have foreseen his death, and the tax benefit was simply part of his financial strategy to maximise member concessions. At the time he made the re-contribution there was no certainty he would not have fully exhausted his super balance and therefore there was no certainty his son would have received a tax benefit . It is unlikely that Part IVA would apply but the ATO look at each situation on a case-by-case basis.