What Is ECPI in an SMSF?

Exempt current pension income (ECPI) is a significant tax concession available to SMSFs and other complying superannuation funds. A fund’s investment income can be substantially reduced or even eliminated, resulting in a lower tax liability. This can even result in a tax refund when funds have franking credits.

What is ECPI?

Exempt current pension income is income earned on assets supporting retirement phase pensions (excluding transition to retirement income streams) and is tax-free. An actuary calculates the percentage of a fund’s total income that is tax-free, excluding assessable contributions and non-arm’s length income.

There are two calculation methods, restrictions on when segregation can be used, and, in limited circumstances, the fund can opt out of using segregation.

What are the two methods used to calculate ECPI?

An actuary will calculate an SMSF’s ECPI using one of the following two methods:

• the segregated method, or
• the proportionate or actuarial method

What is the segregated method?

Assets can be set aside and used specifically to generate income to support pensions in the retirement phase. Investment income, including capital gains, is fully exempt from tax and is not included in the fund’s tax return. Any capital gains or capital losses are ignored, and capital losses cannot be carried forward to offset future capital gains. Direct investment expenses relating to segregated assets are also ignored and not tax-deductible. No actuarial certificate is required to calculate ECPI. Pension assets can be segregated either by direction or simply deemed to be segregated.

Directed segregation

The trustee can allocate specific assets, such as property, a portfolio of shares, or managed funds, to a specific member account to support pension income. All income, including increases in market value and capital gains, and expenses in relation to those assets are allocated directly to the pension member account. The segregation method is unable to be used if the fund has disregarded small fund assets.

Hint – An SMSF can still allocate specific assets to a member’s pension account even if the segregation method cannot be used to determine the ECPI. The actuarial method will then be used instead.

Deemed segregation

Deemed segregation occurs automatically when all the fund’s members are in the retirement phase for the entire financial year, from 1 July to 30 June, even if the fund has disregarded small fund assets. The trustees do not have to specifically set aside assets for segregation.

Segregation and disregarded small fund assets

When a fund holds disregarded small fund assets (DSFA), it cannot use the segregation method, for tax purposes, unless the fund is in 100% retirement phase for the entire income year (deemed segregation). An SMSF has DSFA when the following occurs:

Your SMSF is paying at least one retirement phase income stream

Any member of your SMSF has a total super balance (TSB) over $1.6 million and is also receiving a retirement phase income stream on 30 June in the previous year from any fund, such as an APRA small fund or a retail, industry, or public sector fund. The retirement phase income stream does not have to be from their SMSF.

What is the proportionate or actuarial method?

The most common way of calculating ECPI is the actuarial method. It is much easier to administer because an actuary determines the exempt portion of the fund’s income, which is then applied to the fund’s total investment earnings. The actuarial method is generally used when a fund has both accumulation-phase and retirement-phase income.

Can an SMSF choose not to use the segregation method?

Prior to 1 July 2021, an SMSF was required to use the segregated method when eligible. This made calculating a fund’s ECPI complex when the fund had mixed periods of partial and full pension income. From 1 July 2021, an SMSF can choose to apply the actuarial method for the entire year under the following circumstances:

• the SMSF is not in 100% pension mode for the entire year, and
• the DSFA rule does not apply

The choice is made when the fund’s tax return is lodged. The SMSF should maintain records to document the decision-making process. Being able to choose the actuarial method, typically when a pension is commenced, or contributions are received during the year and applying a simple percentage to all of the fund’s investment income simplifies the application of the ECPI.

Can an SMSF segregate assets to a member’s accumulation account?

Yes, it is possible to segregate, or set aside, specific assets for a member still in the accumulation stage. The income generated from those assets is not exempt from income tax. This may be done for a number of reasons, including differences in members’ retirement timelines and risk profiles. This is often referred to as member investment choice.

What is the effect of ECPI on Div 296 tax calculation?

Under Division 296 tax calculation, the ECPI is not exempt but is added back and included in the calculation of income earned.

In summary, a general rule of thumb when applying the correct ECPI method is:

• Is the fund partly in the accumulation and pension phases? If so, the actuarial method will likely apply, and an actuarial certificate is required.
• Is the fund in 100% pension mode for the entire year? If so, the segregated method will apply, and no actuarial certificate is required.
• Is the fund only in the full pension phase for part of the year? If so, there may be a choice to apply the actuarial method to the entire year instead of applying the more complicated method of using a mix of the segregated method and the actuarial method to periods of partial and full pension in the same year. This assumes the fund is not subject to the DSFA rule.