Why negative earnings in super have far-reaching implications

By William Truong, Technical Services Manager

As the financial year draws to close, the impact of COVID-19 on investment markets means many Australians face the prospect of ending the 2019/20 financial year with a smaller super balance than they had when the year started.

The impact of negative earnings has far-reaching implications, particularly on the values of  taxable and preservation components in super. In this article we explain how negative earnings in super could affect your clients.

How do we calculate the taxable components in super?

The calculation of the taxable components in super funds is based on the proportional rule under section 307-125 of the Income Tax Assessment Act 1997.

For income streams such as account-based pensions, the tax-free and taxable components and their respective proportions are fixed when the pension starts. The same fixed proportions apply for all income and lump sum payments, including super death benefits. Any positive or negative earnings within that pension is attributed with the same tax proportions. The tax proportions will affect the liability to taxation (where applicable).

Taxable and tax-free components in accumulation phase

For accumulation accounts, the tax-free and taxable components are only calculated when a super benefit is paid as a lump sum or on rollover, for example, upon a commutation event. This means taxable components are only notional until a commutation is made.

As a reminder, the three steps below explain how to calculate the tax-free and taxable components:

  • Step 1: Identify the tax-free and taxable components of the total super fund account balance immediately prior to the benefit being paid.
    • The tax-free component = the crystallised segment1 at 30 June 2007 plus the contributions segment2 (tax-free contributions and any amounts rolled in after this date) less tax-free components paid from the fund.
    • Taxable component = total super fund account balance – tax-free component.
  • Step 2: Determine the proportion of tax-free and taxable components of the total superannuation interest.
  • Step 3: The proportion calculated from Step 2 must then be applied to the benefit payment to determine its tax components.
Case study

Accumulation: calculating tax components on commutation

Ben has a super fund which has a balance of $400,000 with the following tax components:

Super balance as at Year 1Tax components
$400,000

$350,000 tax-free

$50,000 taxable

He wishes to take a lump sum of $10,000 (assuming he meets a condition of release):

  • Step 1:
    • Tax-free component = $350,000
    • Taxable component = $50,000 ($400,000 – $350,000)
  • Step 2: the proportion of tax-free ($350,000/ $400,000 = 87.5%) and taxable components (12.5%) of the total superannuation interest.
  • Step 3: 87.5% x $10,000 = $8,750 tax-free with the balance of $1,250 being taxable.

How do positive earnings affect the taxable and non-taxable components?

If there are positive earnings, the super fund will accrue these towards the taxable component only.

Case study

Accumulation: positive earnings

Continuing with Ben’s previous example – let’s assume he hasn’t taken the $10,000 lump sum and the fund balance has increased to $430,000. We now have the following tax components:

Super balance at Year 2Tax components
$430,000

$350,000 tax-free

$80,000 taxable ($430,000 - $350,000)

The positive earnings have been attributed to the taxable components. These values are only calculated upon a commutation being made. The proportion of the tax-free component to the total account balance has now been reduced from 87.5% to 81.4%.

How do negative earnings affect the taxable and non-taxable components?

In contrast, negative earnings in super reduces the tax components in the following order:

  • first reduce the taxable components
  • then reduce the tax-free components.
Case study

Accumulation: large negative earnings

Continuing with Ben’s example – let’s assume he hasn’t taken the $10,000 lump sum and his super balance is reduced by a large amount in year 2:

Super balance at Year 2Tax components
$300,000

$300,000 tax-free (potential of $350,000)

Nil taxable ($300,000 - $300,000)

The super balance has fallen by $100,000. As this is greater than the original taxable component of $50,000 it reduces the taxable component to nil. Next, it also reduces the tax-free component by $50,000 to $300,000. The proportion of the tax-free component relative to the total account balance has increased.

These amounts are notional values, which means they haven’t been calculated yet. The tax-free component can still potentially be restored back up to $350,000 when there are positive earnings if we assume no commutations are made, the fund remains open and there are concessional contributions made.

How else can the tax-free and taxable components change?

There are a number of ways the tax-free and taxable components can change. To explain this, let’s look at the following situations for Ben:

  • Closes his account by rollover to another super fund
  • Keeps the same account open
  • Transfers his super benefits entirely to start a pension.

Rollover to another super fund

Case study

Accumulation: rollover to another super fund

If Ben is unhappy with his fund’s performance and decides to rollover to another super fund, the following applies.

Super balance at Year 2Tax components
$300,000

$300,000 tax-free (now capped at $300,000)

Nil taxable ($300,000 - $300,000)

If Ben closed his account in year 2 and rolled over to another super fund, fund A will calculate the tax components before rolling over to fund B.

There is no taxable amount at the time of calculation as the negative earnings first reduces the taxable component to zero and the tax-free component is set at $300,000.

The new fund will record a tax-free component of $300,000, which is the capped amount. The tax-free component can however increase if Ben makes additional tax-free contributions or further rollovers with tax-free components.

Keeping the same super account open

Case study

Accumulation: keeping the same super account open

If Ben retains his super fund and it experiences positive earnings in the following year, then, assuming no commutations have been made, the following applies:

Super balance at Year 3Tax components
$330,000

$330,000 tax-free (potential of $350,000 is retained)

Nil taxable ($330,000 - $330,000)

If the fund now experiences positive earnings again, from $300,000 to $330,000, the notional value of the tax-free components is now $330,000 and the potential tax-free component of $350,000 is retained as earnings can effectively restore the tax-free component back to this potential level.

Rollover to start a pension

Case study

Accumulation: commencing a pension which meets a condition of release

If Ben can meet a condition of release, he may commence an income stream, such as an account-based pension, and lock-in in a higher proportion of tax-free components.

Pension balance at Year 2Tax components
$300,000 full account-based pension (100% tax-free pension)

$300,000 tax-free (crystallised at $300,000)

Nil taxable ($300,000 - $300,000)

If Ben uses $300,000 to start an income stream, the tax-free proportion is calculated at 100% rather than 87% if he commenced it earlier in year 1.

All payments, including death benefit, from the pension are 100% tax-free and any future positive earnings will be added to the tax-free components only.

If Ben later decides to roll back into accumulation and start a new pension, it may not be 100% tax-free due to earnings while in accumulation phase.

In anticipation of a rising investment market, clients who can meet a condition of release may be able to commence an income stream, such as an account-based pension or transition to retirement pension, therefore locking in in a higher proportion of tax-free components.

How do negative earnings using rollovers from multiple super funds affect the tax-free and taxable components?

In the case studies below, we explain how the rules affect rollovers with multiple super funds when clients want to consolidate their funds.

Case study
Jan – multiple super funds

Jan has two super funds. Consider the following super balances in year 1:

Super balance at Year 1 – ABC super fundSuper balance at Year 1 – XYZ super fund

$350,000 tax-free

$50,000 taxable

Nil tax-free

$300,000 taxable

$400,000 total super balance$300,000 total super balance

Consider the following super balances in year 2 with negative earnings of 20%:

Super balance at Year 2 – ABC super fundSuper balance at Year 2 – XYZ super fund

$320,000 tax-free (notional tax-free of $350,000)

Nil taxable

Nil tax-free


$240,000 taxable

$320,000 total super balance$240,000 total super balance

Comparison of Jan’s consolidation options:

Consolidate into ABC Super fundConsolidate into XYZ super fund

$350,000 tax-free (value of potential tax-free amount)

$210,000 taxable ($560,000- $350,000)

$320,000 tax-free (set at the time of calculation)

$240,000 taxable ($560,000 - $320,000)

$560,000 total super balance $560,000 total super balance

If Jan rolled her whole interest from Fund ABC to Fund XYZ, the XYZ fund would inherit the proportions of her original super interest that existed in ABC fund immediately prior to the rollover. That is, the rollover amount of $320,000 would be 100% tax free. The trustee of Fund XYZ would then use this amount and proportions of the rollover benefit to calculate the components of Jan’s super interest in the Fund.

Therefore, by rolling Fund ABC to Fund XYZ, Jan would effectively reduce her tax-free component by $30,000, originally it was $350,000.

Alternatively, if Jan consolidates her super into the ABC fund, she would retain the higher $350,000 tax-free component.

How do negative earnings impact preservation components?

The recent investment market declines can affect any ‘Unrestricted non-preserved’ super benefits your clients may have in their super fund. Unrestricted non-preserved benefits allow clients to have access to these amounts at any time because they have previously met a condition of release in respect of these amounts.

Positive earnings in super funds only increase the member’s ‘Preserved’ benefit.

In contrast, under section 6.16A of the Superannuation Industry (Supervision) Regulations 1994 (SISR), negative earnings in super funds impact the preservation components in the following order:

  • First reduce preserved benefits
  • Then reduce restricted non-preserved benefits (RNP)
  • Then reduce unrestricted non-preserved benefits (URNP).

Super fund earnings are generally credited/debited to preservation components at 30 June each year. However, this date may differ between super funds so it’s best to confirm the date with the relevant super fund.

Once negative earnings are debited to RNP and URNP components, these components become fixed and are permanently reduced, unlike the tax components discussed above.

Case study
Jenny – negative earnings impacting super preservation components

Jenny’s super balance as at year 1 (reporting date)

Super balancePreservation components
$300,000

$260,000 unrestricted non-preserved

$40,000 preserved components

Jenny’s super balance as at year 2 (reporting date) – drops by 20% (equating to $60,000)

Super balancePreservation components
$240,000

$240,000 unrestricted non-preserved

Nil preserved components

The first step is to reduce the preserved components to zero. The negative earnings are larger than the preserved components. The excess of $20,000 reduces the unrestricted non-preserved components. At the reporting date, in this example we have assumed this to be 30 June 2020, Jenny’s super fund calculates her preservation components and the unrestricted non-preserved component reduces by $20,000 permanently.

Later, when investment markets recover and Jenny’s super goes back up to $300,000 and her unrestricted non-preserved benefit remains at $240,000 and cannot increase back up to its original value of $260,000, presuming she does not meet a new condition of release.

Alternatively, if Jenny contributes $20,000 or accepts a rollover from another super fund before 30 June 2020 her preservation components will be as shown below. Jenny avoids any reduction to her unrestricted non-preserved benefits:

Super balancePreservation components
$260,000 ($240,000 + $20,000)

$260,000 unrestricted non-preserved

Nil preserved components

When topping up super, the super fund must first increase the unrestricted non-preserved component, as it’s the preserved components that is first impacted by the negative earnings. In this case, the reduction from the previous reporting date from $300,000 to $260,000 is only $40,000, which reduces the preserved component to nil. There is no excess reduction to reduce the unrestricted non-preserved components.

The aim is to ensure your client’s total benefit is equal to or greater than the original value of their unrestricted non-preserved benefits in the fund.

In conclusion

Large negative losses not only impact a client’s retirement savings, they can also impact a client’s taxable components and preservation components. By understanding these rules, advisers can better assist clients to preserve their tax-free component and unrestricted super benefits.

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[1]  The crystallised segment of a super interest is a fixed dollar figure based on the 30 June 2007 value of the following components: concessional component + post-June 1994 invalidity component + undeducted contributions + CGT exempt component + pre-July 1983 component.
[2]  The contributions segment of a super interest consists of contributions made after 30 June 2007 to the extent that they have not been included in the assessable income of the super fund, for example, non-concessional contributions.


More information

If you have any questions, or would like more information, please contact the IOOF TechConnect team on 1300 650 414.

Disclaimer
The information in this section of the website is intended for financial advisers only and is not to be distributed to clients. It has been prepared on behalf of Australian Executor Trustees Limited ABN 84 007 869 794 AFSL 240023, IOOF Investment Management Limited ABN 53 006 695 021 AFSL 230524, IOOF Investment Services Ltd ABN 80 007 350 405, AFSL 230703 and IOOF Ltd ABN 21 087 649 625 AFSL 230522 based on information that is believed to be accurate and reliable at the time of publication.