Minimising death benefit taxes for your SMSF clients
Death benefit taxes can have a significant impact on your clients’ inheritance, but careful estate planning can help minimise the damage.
Australia made history in the late ‘70s as one of the first developed countries to abolish death duties on deceased estates. Since then there have – officially – been no death duties in Australia. This is at least what the government wants you to think.
Unofficially, death duties have continued to exist in Australia – albeit by another name – as death benefit taxes levied on our superannuation. Given that superannuation assets now exceed $2.05 trillion, death benefit taxes are likely to have a significant impact on the inheritances of the next generation. Careful planning can, however, minimise or altogether avoid the imposition of death benefit taxes.
Superannuation dependants v tax dependants
A ‘superannuation dependant’ is a person who is a dependant for the purposes of the Superannuation Industry (Supervision) Act 1993 (the SIS Act). This includes a member’s spouse, children, step-children and a person with whom the member was in an interdependent relationship.
A tax dependant on the other hand is a person who meets the definition of a ‘death benefits dependant’ under division 302 of the Income Tax Assessment Act 1997 and is based on a much narrower definition. Tax dependants under division 302 include a spouse and children under the age of 18. It is possible for an adult child (or any other person) to qualify as a tax dependant if they are able to establish dependency under the tax rules.
A tax dependant enjoys the benefit of not being subject to death benefit taxes on any lump sum superannuation benefits that they receive from a deceased member.
Death benefit taxes
The effect of the superannuation dependant and tax dependant rules is that adult non-dependent children can be nominated to receive superannuation under a binding death benefit nomination, but will not meet the definition of a tax dependant and will therefore be subject to death benefit taxes.
The quantum of death benefit taxes will ultimately depend on the tax-free and taxable components of the lump sum.
The tax-free component comprises non-concessional contributions made by the member after 1 July 2007 as well as any crystallised segment. No death benefit taxes apply to the tax-free component.
The taxable component comprises a taxed component and an untaxed component. The taxed component is that part of the fund which has been taxed within the fund. It includes concessional contributions and fund earnings. The untaxed component includes that amount which has not been taxed in the fund, such as a life insurance policy.
Where a non-tax dependant receives a lump sum superannuation benefit, the following death benefit tax rates will apply:
• Nil on the tax-free component;
• Up to 15 per cent plus the Medicare Levy on the ‘taxed’ component of the ‘taxable component’; and
• Up to 30 per cent plus the Medicare Levy on the ‘untaxed’ component of the ‘taxable component’.
Minimising death benefit taxes
Through careful planning, death benefit taxes can be minimised, if not avoided altogether.
Withdrawal re-contribution strategy
A common strategy to minimise death benefit taxes is a withdrawal and re-contribution strategy. It involves a member having met a condition of release, withdrawing a lump sum from their superannuation and re-contributing it back into the fund as a non-concessional contribution in order to convert the taxable component into tax-free benefits which won’t be subject to death benefit taxes.
The current non-concessional contribution would allow a member to contribute $180,000 per year or $540,000 in one year using the bring-forward provisions. It is crucial that advice always be sought to ensure that contribution caps are not exceeded.
Superannuation proceeds will trust
Where a lump sum death benefit is paid to the executor of the deceased, whether death benefit taxes apply will depend on whether a tax dependant has benefitted or is likely to benefit.
The effect of section 302-10 is that death benefit taxes will apply to the extent that the executor is unable to show that a beneficiary who has benefitted is a tax dependant. Under a will with testamentary trusts, if the primary beneficiary of a testamentary trust is a tax dependant but the other beneficiaries are not, it will be difficult for the executor to show that only the tax dependant benefited.
In order to minimise the risk of this, all members should ensure that they have a sufficient provision in their will that allows the executors to hold any benefits in a superannuation proceeds will trust as a separate sub-trust which limits the beneficiaries to the member’s tax dependants.
Withdrawing benefits before death
Another potential strategy is for a member, having met a condition of release, to withdraw all of their benefits before death so that no death benefit taxes will apply to benefits that pass to adult children.
All members should ensure they have an appropriate enduring power of attorney in place such that in the event that they are incapacitated and terminally ill or about to die, their attorney can withdraw all of their benefits.
This strategy should be used with severe caution as, in the event that the member does not die, they may be unable to re-contribute those benefits back into the fund and will therefore be subject to marginal rates of tax on any earnings.
Death benefit taxes don’t appear to be going anywhere any time soon, and with the current amount of wealth inside superannuation and the current budget deficit, it is likely the ATO will focus resources on the enforcement and collection of these taxes. With appropriate planning, you can ensure that beneficiaries receive the maximum benefit of their inheritance.
Vik Sundar, managing director, Chamberlains Law Firm
