How to: Minimise tax on lump sum death benefits

Superannuation may form a large part of any individual’s wealth. Consequently, it may also form a large part of the assets available to pass to beneficiaries upon death. It is therefore important to review how these funds are to be passed onto beneficiaries.

Left unattended, superannuation benefits may be taxed up to 30.0% before passing onto an individual’s beneficiary. Unlike assets outside of superannuation, superannuation benefits do not form part of a deceased’s will and estate. Assets within superannuation are instead subject to the Superannuation Industry (Supervision) Act 1993 (SIS ACT) in relation to distribution and taxation.

In order to ascertain what options are available to minimise tax on superannuation benefits being passed on, it is important to break down the different parts of an individual’s superannuation fund. Superannuation may be broken into two components; the taxable component and tax-free component. The value of these components will determine how much tax (if any) may be payable by the beneficiary of an individual’s superannuation benefits upon death.

Further to this, the type of beneficiary receiving the benefits from a deceased superannuation fund may also influence whether or not those benefits are taxed.  This can be broken down as either a ‘dependant’ or ‘non-dependant’ for the purposes of both superannuation law and taxation law.

What is the Taxable Component?

The taxable component of a superannuation fund can be further divided into a taxed element and an untaxed element.

  • The taxed element is made up of superannuation contributions over the years that were contributed with pre-tax dollars and paid 15.0% tax going into the superannuation fund (contribution tax).
    This includes any salary sacrifice, concessional contributions, and employer Superannuation Guarantee Contributions (SGC).
  • The untaxed element is made up of any superannuation contributions that have not yet paid any tax in either an individual’s personal name or at the superannuation concessional rate (15.0% contributions tax).
    Untaxed super components are generally sourced from government superannuation providers such as public sector super schemes or constitutionally protected funds or may also be proceeds from insurance policies held by the superannuation fund.

What Is The Tax-Free Component?

The tax-free component of a super fund is the component where the contributions are sourced with after tax dollars.  This means the individual has already paid the tax in their own names and subsequently decided to put the money into superannuation.

Who Is Dependant Under Superannuation Law?

When the proceeds of a superannuation fund are passed to a beneficiary, the trustee must review superannuation law and whether the individual is a dependant or non-dependant.

A dependant under superannuation law is as follows:

  • A spouse of the deceased, including members of de facto couples;
  • A child of the deceased; or
  • Someone with whom the deceased was in an interdependency relationship.

If the beneficiary does not fall into any of the three above, they are generally considered a non-dependant for the purposes of superannuation law.

It is important to note that superannuation benefits may only be paid to dependants under superannuation law.
Should a member of a superannuation fund desire to pay a non-dependant beneficiary, funds can be directed to the legal personal representantive (estate) and then directed to the desired individual via a will.

Dependant – Tax Law

Once dependency under superannuation law has been ascertained, the next step is to determine dependency under the tax laws. The Income Tax Assessment Act 1997 (Tax Act) provides the definition of a death benefit dependant.

Under these laws a dependant is:

  • A spouse of the deceased, including members of de facto couples;
  • A former spouse;
  • A child under 18; or
  • Someone with whom the deceased was in an interdependency relationship at time of death

Similar to superannuation law, if the beneficiary does not fall into any of the points above, they are generally considered a non-dependant for the purposes of taxation law.

The difference between these two laws is largely around the definition of a child dependant. Whereas superannuation law does not specify age, the tax laws deem a child under the age of 18 to be a dependant. This means that adult children are classified as a non-dependant and may be taxed at a higher rate.

Taxation to a Dependant

Once it is determined if the beneficiary is a dependant for both superannuation and tax law the proceeds of the superannuation fund may be paid to the beneficiary.

  • The tax-free component of the benefit is paid to the beneficiary tax-free.
  • The taxed element of the taxable component is paid tax-free to the beneficiary.
  • The untaxed element of the taxable component is also paid tax-free.

Taxation To A Non-Dependant

In the event, the beneficiary of the death benefit is classified as a dependant under superannuation law but a non-dependant under tax law, the benefit may still be paid to the beneficiary.  However, the taxes associated with the benefit differ depending on the component of superannuation being passed on.

  • The tax-free component of the benefit is paid to the beneficiary tax-free.
  • The taxed element of the taxable component is paid to the beneficiary and incurs a 15.0% tax liability.
  • The untaxed element of the taxable component is paid to the beneficiary and incurs a 30.0% tax liability.

In addition to the rates above, the rate of Medicare Levy must also be applied. Currently, this is 2.0%.

What Does It All Mean?

What it all means is that the retirement earnings that an individual has created over time may be further taxed upon transfer to beneficiaries after death.

A worked example can be seen below.

ABC Superannuation Fund Funds Available Tax Rate Tax Payable
 Tax Free Component $200,000 0.0% $0
Taxable Component (Taxed Element) $400,000 15.0% $60,000
Taxable Component (Untaxed Element) $400,000 30.0% $120,000
Subtotal $1,000,000 $180,000

What we can see from the example above is that upon death, the benefits of a superannuation fund passed to a non-dependant for tax purposes would incur a tax liability of $180,000.

What can also be observed in the example above is that the tax-free element does not impose any tax liability to a non-dependant for tax purposes.

Therefore if we are able to increase the tax-free component of a superannuation fund, we may be able to reduce the amount of tax payable by dependents upon death (potentially saving up to $180,000 in tax).

How Do We Manage and Minimise the Tax Payable?

Through the use of superannuation withdrawals and contributions, we are able to increase the level of the tax-free component of a members superannuation account. This is commonly referred to as a re-contribution strategy.

Individuals withdraw benefits from an existing superannuation fund and subsequently make after tax superannuation contributions into superannuation.  By doing this the components of an individual’s superannuation fund will change and ultimately become 100.00% tax-free.

This may not be able to be done in one transaction but over time and with the right parameters a non-dependant for tax purposes may potentially receive superannuation benefits without any tax liability to pay.

What Are the Risks/Disadvantages?

Superannuation legislation is constantly changing. It is important to be aware of the current laws in order to be able to maximise an individual’s death benefit.

Other factors such as age, previous superannuation contributions, types of superannuation funds and employment arrangements need to be taken into consideration, and if not adequately considered may hinder the potential benefit of transitioning a taxable superannuation fund into a tax-free superannuation fund.

Each situation is different and depending on who the beneficiary of the superannuation death benefit is, and the taxable/tax-free makeup of the superfund will determine if a re-contribution strategy is appropriate.

How Does The Strategy Affect Me?

The process of increasing the tax-free component of an individual’s superannuation benefits often involves pension payments and after tax superannuation contributions.

As such it needs to be considered how additional pension payments will affect an individual’s overall position.  Whether an increased pension payment will result in a reduction in social security payments or whether an individual needs to meet the work test in order to contribute to superannuation.

Fortunately, if you are over age 60, a withdrawal from superannuation/pension payment will not incur a different rate of tax to you. Irrespective of whether your superannuation is 100% taxable or 100% tax-free.
In summary, whilst there may be tax benefits to your future beneficiaries to transitioning your superannuation benefits from the taxable component to the tax-free component it is important to be aware of the potential pitfalls that may occur.

Between taxable components, contribution limitations, age restrictions and the ever changing environment that is superannuation, it is recommended that all individuals interested in increasing the tax-free component of their superannuation benefits enlist the support of a specialist.

If you would like support in increasing the tax-free component of your superannuation benefits, please feel free to contact the office of M&A Wealth and an adviser will be happy to discuss your options with you.

General Advice Warning

The information provided in this article is general in nature and does not constitute personal financial advice. Before acting on any information, you should consider the appropriateness of the information provided having regard to your current position