Avoiding the Super Inheritance Tax Trap

Michelle Bromley CFP®, Director – Strategy and Advice

While death duties were abolished in Australia decades ago, a quasi-estate tax remains in the form of tax levied on the taxable component of a superannuation (super) death benefit paid to certain beneficiaries, particularly adult children. In this article, we cover some key concepts of superannuation estate planning.

Who can receive my super?

Your super is intended to benefit you in retirement, or to provide support for your dependants on your death.

Your dependants generally include your spouse and children plus financial dependents, among others.

If you haven’t made a death benefit nomination the super fund trustee will investigate who your dependants are and exercise their discretion in paying the benefits appropriately.

Alternatively, they may pay the benefits to the Legal Personal Representative for your estate who then adopts the responsibility to distribute to your beneficiaries.

A death benefit nomination allows you to direct your death benefits to your preferred beneficiaries. Most super funds will allow you to make a non-lapsing nomination that the trustee views as binding, giving you greater certainty that your legacy will be paid as intended.

Which beneficiaries get my death benefit tax-free?

Recognising that your super is intended to provide support for people who are dependant on you at the time of your death, the term ‘death benefits dependant’ is applied to the following individuals who can receive your death benefit tax-free:

  • Your spouse
  • Your children under the age of 18
  • Any person financially dependent on you
  • Any person with whom you are in an interdependent relationship.

Generally, the benefit can be paid to these people as a lump sum or as an income stream. A minor child can continue receiving a death benefit income stream only until they reach age 25.

Which beneficiaries get taxed on my death benefit?

Unfortunately, not all beneficiaries of super death benefits are equal. Beneficiaries who are entitled to receive a benefit under the superannuation law, such as adult children who are not fully financially dependent, may not be entitled to receive all benefits tax-free.

Generally, these beneficiaries are restricted to receiving lump sum benefits.

Your super benefit is comprised of up to three tax components.

  1. The tax-free component is always received tax-free.
  2. The taxable component is received tax-free by ‘death benefit dependants’ but is taxed at up to

    • taxed element – 17% (inc Medicare levy)
    • untaxed element – 32% (inc Medicare levy)

It’s important to note that the benefit is taxed at the recipient’s marginal tax rate, up to the maximum tax rates shown above.  Therefore, a non-earning adult child with a tax-free threshold of $22,801 (including the Low and Middle Income Tax Offset for FY 2021) may be able to receive up to around $134,000 of taxable component before any tax is paid.


Case Study

John is 60 and has $1,000,000 in his SMSF, all taxable component.

He has three children – two financially independent and income earning adult children from his first marriage and a 13-year-old daughter from his second marriage, whom he loves and wishes to benefit from his super and non-super assets equally.

He nominates his super benefits to be paid in equal thirds to each child. Should John die, his minor daughter receives $333,333 while each of his adult children are paid $276,666 and the ATO gets tax revenue of $113,333.

How can I better plan to minimise this tax?

Cash out and recontribution strategy

The first strategy is useful if you have access to your super, for example, you’ve had a change of employment over age 60 but you’re still under age 67 and eligible to contribute.

A re-contribution strategy is a withdrawal of a super lump sum that is contributed back into super as an after-tax contribution. It has the effect of ‘washing out’ the taxable component that is withdrawn.

If you’re under age 60 you may have some tax to pay on the taxable component of the withdrawal, but if you’re over 60 the withdrawal is tax-free.


Case Study

John has stopped working and wants to start an income stream.

John receives advice to cash out $400,000 tax-free in early June and to use the proceeds to make a $100,000 after-tax contribution later in June plus a $300,000 contribution in early July. After all of the recontributions have been made John starts a pension with his entire benefit (40% is the tax-free proportion).

Should John die, his minor daughter receives $333,333 while each of his adult children are paid $299,333 and the ATO gets tax revenue of $68,000.

Quarantining and directing benefits

The second strategy involves starting pensions at different times to separate taxable benefits from the re-contributed amounts mentioned above, which are always received tax-free.

For example, starting one pension in June before you make the recontribution allows you to start a second pension in July with just the tax-free amounts.  This is a common strategy within SMSFs but can also be achieved using multiple pension products from a regular super fund provider.

Building on this, consider who your ‘death benefit dependant’ beneficiaries are and whether you can direct taxable benefits to them, while directing tax-free benefits to adult children (or other non-death benefit dependant beneficiaries).


Case Study

John receives advice to commence an income stream for $600,000 on 1st June before cashing out the $400,000 to make the after-tax contributions.

John was advised to commence a second income stream in early July with the $400,000 tax-free benefits.

John adjusts his binding nomination to direct the first pension containing taxable benefits to his minor daughter, who can continue to receive this income stream tax-free until age 25 when it becomes a tax-free lump sum. John directs his tax-free pension to be paid as a lump sum divided equally between his adult children.

In the event of his death, his minor daughter receives $600,000 while each of his adult children are paid $200,000 and the ATO gets nothing.

John alters his Will to provide his adult children with top-up bequests from his non-super assets to be fair and equitable between all three children.

Withdrawal prior to death

Of course, passing on wealth can be done prior to death by withdrawing super benefits and potentially gifting an early inheritance.

This strategy can be used by those who have achieved a condition of release and can receive benefits tax-free, including:

  • Aged 60+ with ‘unrestricted non-preserved’ benefits
  • Preservation age to age 59 with ‘unrestricted non-preserved’ benefits – the 1st $215,000 is tax-free
  • Aged less than 60 diagnosed with a terminal medical condition.

The final strategy works well for those who unfortunately suffer a slower decline or are diagnosed with a terminal illness and have time to put a withdrawal plan into action.

Importantly, to avoid the situation where your illness means you have lost capacity to make decisions and take appropriate action, you should give a trusted person an Enduring Power of Attorney with instructions to withdraw your super in full if it appears death is imminent.


Case Study

Having recently commenced his pensions, John is diagnosed with a terminal illness and has only six months to live.

John cashes out pension #1 completely which is received by him tax-free. He holds this in a bank account in his personal name to be dealt with via his Will.

John changes his binding nomination to direct pension #2 to his minor child, to ensure she continues to receive an income stream to age 25. He does not directly benefit his adult children via his super.

John changes his Will. He includes a testamentary trust that holds the $600,000 cash at bank and his other non-super assets in trust for his children, with benefits to be split in a fair and equitable way between the three of them taking into account the super benefit received by the youngest.

In the event of his death, his minor daughter receives $400,000 from his super while each of his adult children have $300,000 and the ATO gets nothing.

The further benefit of the testamentary trust is that income earned from assets held within the trust can be streamed to the minor child but are subject to adult tax rates – gaining an extra tax-free threshold.

Summary

The best way to avoid ‘gifting’ part of your super to the ATO is to plan ahead.

A comprehensive estate planning strategy considers both super and non-super assets, and how to affect the best chance of those benefits flowing into the hands of intended beneficiaries.

Each of the scenarios above has its advantages and disadvantages, and dangers for those who go it alone without obtaining appropriate advice.

Contact us for a discussion with an adviser to discuss how best to minimise death benefit tax in your situation.

To speak to our client services team, please call 1800 064 959 or click here to contact us.

The information in this article contains general advice and is provided by Primestock Securities Ltd AFSL 239180. That advice has been prepared without taking your personal objectives, financial situation or needs into account. Before acting on this general advice, you should consider the appropriateness of it having regard to your personal objectives, financial situation and needs. You should obtain and read the Product Disclosure Statement (PDS) before making any decision to acquire any financial product referred to in this article. Please refer to the FSG (www.primefinancial.com.au/fsg) for contact information and information about remuneration and associations with product issuers. This information should not be relied upon as a substitute for professional advice, and we encourage you to seek specific advice from your professional adviser before making a decision on the matters discussed in this article. Information in this article is current at the date of this article, and we have no obligation to update or revise it as a result of any change in events, circumstances or conditions upon which it is based.

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