Death and (Superannuation) Taxes
There is no question that death – whether expected or unexpected – is a painful topic to discuss. Unfortunately, along with taxes, it is one of only two certainties in life according to Benjamin Franklin.
In this article we will consider the two topics together and look at the tax consequences when someone dies and how that relates to superannuation benefits. This won’t be a complicated, highly technical piece (we can leave that for the lawyers and financial planners) but rather a simpler explanation of what you need to know so that you will feel informed if you should ever find yourself in this situation.
Let’s start with some basics…
One of superannuation’s specific purposes (along with providing for your retirement) is to provide a benefit on death to those dependent on the deceased. Increasingly, people are looking to superannuation to provide a core level of life insurance as well as long term savings for retirement and therefore many fund members have a lot more in ‘super’ than they think when it comes to a death benefit. Employer based super plans almost always have an amount of life insurance cover attached to their plans so that even new members may have a death benefit in the hundreds of thousands of dollars with only a very small fund balance.
It’s probably worth understanding a little about this, don’t you think?
OK, so let’s start with a few basics. We can consider that there are three players in the picture when talking about superannuation and death:
- The first is the super fund, or more specifically the trustees of the super fund, who manage and make decisions regarding how your money is invested and how and when the funds are released when eligible (for example retirement, death or possibly hardship).
- The second is the super fund member who ‘owns’ the account and is responsible for contributions, basic investment selection and, importantly, nominating beneficiaries to receive any proceeds on death.
- The third are the beneficiaries nominated as above who will receive the proceeds if the member dies. But beneficiaries are specifically defined in superannuation legislation so unlike ordinary life insurance, you can’t nominate just anyone.
Who can be a beneficiary?
The Superannuation Industry Supervision (SIS) Act makes it very clear that only a small number of types of beneficiaries can receive superannuation proceeds (‘SIS’ dependents). These include spouses (including de facto and same sex partners), children of any age (including step-children, adopted children and ex-nuptial children), other people with which you have an inter-dependent relationship or the executor of your will (referred to as your legal personal representative). An inter-dependent relationship usually means where there is a close personal relationship (whether or not related by family), who live together and one or each of them provides the other with financial and domestic support and personal care. This might include, for example, elderly siblings who look after each other.
Fundamentally, that’s it – you cannot nominate your siblings or your parents or a friend and if you do it will be the same as if you nominated no-one. In this case the superannuation trustees will make the decision as to who gets the money.
If you haven’t nominated anyone (or nominated someone who cannot receive the benefit as above) but have a legal will, the trustees will most likely pay the proceeds to your executor for distribution as per the wishes expressed in the will. But if you don’t have a will then the trustees must search for the most appropriate beneficiary. In some circumstances this could be an ex-spouse or ex-partner, and this may not be where you wanted the proceeds to go.
Having even a basic will should provide some comfort regarding where the money goes if you don’t have superannuation beneficiaries, but a properly constructed will should always be the first option.
What about tax?
When benefits are paid from a super fund as a death benefit, the tax is determined by who actually gets the money. If you are classified as a ‘tax dependent’, then the funds are payable to you tax free – it’s that simple. How do you become classified as a tax dependent? Well, first you have to be either a spouse (including de facto and same sex partners), a child under 18 (or under 25 and a full-time student) or someone who is actually financially dependent on the deceased member. Note the point about being under 25 and a full-time student because in this particular circumstance, it might be worth considering taking up studies for a period of time during the claim as the tax saving can be substantial – some advice regarding this is imperative.
Financially dependent means that their basic living needs are being provided by the member at the time of their death.
Being a tax dependent is important regarding the insurance aspect of superannuation because when a death benefit claim is successfully made in a super fund, the insurance company pays the funds into the member’s account as what is known as an un-taxed element (sorry for the technical terms here…). From there, the balance of the fund is paid to beneficiaries and if they do not meet the ‘tax-dependent’ status, then 30% tax will be payable plus the Medicare levy may also be payable. On a $500,000 insurance benefit this can be more than $150,000 tax!
Can there be different types of beneficiaries?
There are three types of beneficiary nominations available with most super funds:
A nominated beneficiary is simply named as a ‘recommended’ beneficiary by the member, but the superannuation trustee is not bound to follow this instruction. For example, if they determined that there was a beneficiary with greater need, they may choose to pay to them instead. In most cases though, where the beneficiary is a spouse or dependent child (i.e. a superannuation dependent) it is unlikely that this discretion would be used.
To be sure that the proceeds are paid where the member wants then a binding nomination should be used. As the name suggests this type of nomination binds the trustees to pay as per this instruction provided that the beneficiary is a superannuation dependent. Because this is a legally binding document there are some extra rules around it such as the requirement to have the nomination witnessed by two independent adult witnesses (who are not beneficiaries) and, depending on the fund, the need to renew the nomination every three years. Failure to renew reverts this a simple nomination.
If the deceased fund member is drawing a pension from their superannuation (if they were already retired for example), then the third type of nomination is available. A reversionary beneficiary provides for the member’s pension to simply keep being paid to a spouse beneficiary and the benefit ‘reverts’ to them.
There are advantages and disadvantages to each of these and this is an area where help can be provided by a financial planner or estate lawyer. It is especially important to get some personal advice regarding nominations where you feel there might be complications such as previous relationships, estranged children or even the potential for legal challenges.
Additionally, and I am going to get a little morbid here, there can be some very real benefits in planning ahead if you find yourself in a situation where there has been a diagnosis made and the outcome might not be as positive as you would hope for. I can really understand that there would be a reluctance to even consider that a life-threatening illness would not be overcome but the sad reality is that not everyone makes it. The further down the path you go, the more difficult it is to address issues because no-one wants to bring up financial matters at a time like this. Of course, it is exactly the time to be dealing with these issues.
A case study might give you an example of where planning ahead can be really beneficial.
Let’s consider a couple with two primary age children. The fund member is the main income earner and the family is reliant on their income while their partner works part-time because of the time it takes to look after the children. After speaking to a financial adviser, they realise that insurance should cover all debts as well as providing money to be invested to assist with everyday living costs, spouse’s retirement and significant other expenses. In this case, the parents were both committed to their children receiving a private secondary education. For arguments sake, lets assume that in addition to the debt repayment, they needed an extra $1.2 million and so they arranged for this to be provided through the member’s super fund.
Investing $1.2 million in a balanced manner would likely produce a taxable income each year of around $50,000 and because the surviving spouse continues to work part-time this would be taxed at between 34.5% and 39.0% (including the Medicare levy, that’s between $17,000 and $19,000). Yikes – that takes a big chunk of the expected income!
There are a couple of options here. We could increase the insurance amount to produce a bigger annual income (but the higher the income the more tax payable) or, we could redirect the death benefit into a Testamentary Trust (TT) that has been built into their wills.
What is a testamentary trust and how can this help?
A testamentary trust is a special type of family trust that can be ‘built-in’ to a will that provides for tax effective distributions to minors (among other things). It is the only type of family trust that treats minors as adults for tax purposes. In normal circumstances, if you tried to re-direct income from investments to your minor children, they would be taxed in a penalty manner where the tax rate can be as high as 47% (actually - a part of it might be taxed at 66%).
Testamentary trusts provide minors with adult tax-free thresholds (currently $18,200) and then the lower marginal rates after that. In the example above, we could re-direct the $50,000 income to the two minor children and they would pay a combined tax of less than $3,000 – certainly much better than the $17,000 - $19,000 discussed above. When you consider that this might be a tax saving every year for 10–15 years the tax saving is very material.
So, let’s summarise:
- You should pay attention to who you have nominated as the beneficiary of your superannuation fund and ensure that it is the right person (or your legal personal representative).
- There is a difference between who can receive super (SIS dependents) and what tax may be payable (tax dependents).
- Remember that the total benefit that may be paid will include the insurance amount and this can be a lot more than just the super balance.
- If there are potential family complications such as blended families or family law disputes you should talk to a specialist financial planner or estate lawyer to ensure that the best outcome is achieved.
- Significant super/insurance benefits and minors mean a testamentary trust should be considered (talk to your estate lawyer).
- If things are grim from a life-threatening illness perspective, seek advice as early as possible – it can really help.