Is Your Defined Benefit Pension Really Tax-Free? A Guide for Retirees

Many Australians assume that once you turn 60, any income you receive from your superannuation pension is completely tax-free. While that's generally true for standard account-based pensions, it's a dangerous assumption for those with a defined benefit lifetime pension.

The tax rules for these pensions are unique and can result in a surprise tax bill if you're not prepared. This guide will break down the rules with clear examples to help you understand how your defined benefit pension is taxed.

Disclaimer: This information is for educational purposes only and is not financial advice. Please verify any calculations with a qualified professional before making financial decisions.

The 2 Key Factors That Determine Your Tax Bill

For retirees over 60, the tax treatment of a defined benefit lifetime pension comes down to two key factors:

1. The Tax Components of Your Pension: Your pension is made up of different "tax components," which you can find on your statement from your super fund. For tax purposes, these are grouped into two sources:
   • The Taxed Source: This includes your tax-free component and your taxable-taxed element.
   • The Untaxed Source: This is your taxable-untaxed element.
2. The Defined Benefit Income Cap: This is a limit set by the government on how much of your defined benefit pension income can receive concessional tax treatment.

Understanding the Defined Benefit Income Cap

Introduced on 1 July 2017, the defined benefit income cap was designed to apply similar tax treatment to defined benefit pensions as the transfer balance cap does for account-based pensions, preventing an unfair tax advantage.

The cap is calculated by dividing the general transfer balance cap by 16.

• For the 2025 financial year, the defined benefit income cap is $118,750.
• From 1 July 2025, as the general transfer balance cap increases to $2 million, the defined benefit income cap will rise to $125,000.

How it Works: A Simple Analogy and the Tax Rules

The easiest way to understand how your pension is taxed is to think of it like stacking Lego blocks against the income cap.

First, we place the taxed source of your pension at the bottom. Then, we stack the untaxed source on top. How your pension is taxed depends on where these blocks sit in relation to the income cap line.

If your total pension is UNDER the cap:

• The taxed source is tax-free.
• The untaxed source is taxed at your marginal tax rate, less a 10% tax offset.

If your total pension is OVER the cap:

• Taxed Source: The portion below the cap remains tax-free. For the portion that exceeds the cap, 50% of the excess amount is taxed at your marginal tax rate.
• Untaxed Source: The portion below the cap is taxed at your marginal rate less a 10% tax offset. The portion that exceeds the cap is taxed at your full marginal tax rate with no tax offset.

The most important rule in this "stacking" method is that the taxed source always gets to use up the cap first.

A Step-by-Step Example: Calculating Tax on a Large Pension

Let’s look at John, who is 62. In the 2025 financial year, he receives a defined benefit lifetime pension of $180,000.

• His taxed source is $120,000.
• His untaxed source is $60,000.

1. Assess the Taxed Source ($120,000)
   The FY25 income cap is $118,750. John's taxed source of $120,000 exceeds this cap by $1,250. 50% of this excess amount ($625) is included in his assessable income to be taxed at his marginal tax rate. The rest remains tax-free.
2. Assess the Untaxed Source ($60,000)
   The income cap has already been fully used up by the taxed source. Therefore, the entire untaxed source of $60,000 is above the cap. This means all $60,000 is included in his assessable income and is taxed at his marginal tax rate with no tax offset.

The Result: For the financial year, John must include a total of $60,625 ($625 from the taxed source + $60,000 from the untaxed source) in his assessable income, and he receives no tax offset on this amount.