Avoiding the superannuation death tax
How to optimise tax savings on superannuation inheritance.
“I recently inherited $200k from a superannuation death benefit and got taxed a huge chunk.”
This was the title of a post I came across scrolling through a financial forum on my Tuesday evening.
At Morningstar we have extensively covered the intergenerational wealth transfer and inheritance and expect to see implications shaping markets in the coming decade.
Despite recent sentiment about using super as a band aid for Australia’s housing crisis, the original intention of the scheme was to provide funds for those in retirement and reduce reliance on the age pension. Australians have accumulated a total of $3.9 trillion in superannuation assets (June 2024).
But what happens if you pass away sooner than expected leaving a sum of wealth for your beneficiaries? Upon death, the Australian Tax Office is entitled to dip its fingers into your funds and take up to 32% of your children’s super inheritance.
Last month, our Senior Investment Specialist, Shani Jayamanne, published an article detailing how your super will be taxed when you die.
In short, Shani’s article outlined that spouses, former spouses, children under 18 and any financial dependents are eligible for preferential tax treatment. Adult children are not categorised as dependents and therefore face different tax treatment.
Tax dependents can be paid out through an income stream or as a lump sum. However, non-dependents only have the option for a lump sum payment. For further information on how this works you can read Shani’s article here.
This article seeks to explore how to reduce the superannuation death tax in the event your beneficiaries (e.g. adult children) are not classified as tax dependants.
How to avoid the death tax
Re-contribution strategy
Pre-tax dollars termed ‘concessional contributions’ such as compulsory employer contributions form part of the ‘taxable’ component of the superannuation death benefit. Non-concessional contributions are funds paid to your super account which have already been subject to tax and therefore are not liable to be taxed again upon your death.
A recontribution involves withdrawing a lump sum (often capped) from your superannuation account and recontributing the money back into the fund to help reduce the tax liability left to non-dependants. The aim is to gradually reduce the taxable component of your superannuation account by recontributing your withdrawals back as non-concessional contributions.
The result of this is that the recontributed funds (non-concessional) aren’t subject to the superannuation death tax as they are now non-taxable. This is most suited to Individuals who are under 75 or those under 60 who have met a condition of release and wish to commence a retirement income stream.
Naturally, the re-contribution scheme is constrained by the non-concessional contribution caps that determine the maximum amount an individual can contribute per year. However, this can be changed in you are eligible for the bring forward rule.
This rule allows an individual to bring forward the equivalent of 1 or 2 years of your annual cap from future years. In practise this means you can make contributions up to 2 or 3 times the annual cap amount in the first year of the bring-forward period. Another eligibility criteria is that the bring-forward rule is only available for those under 75 years if their super balances on 30 June of the previous financial year was less than $1.66 million from 1 July 2024.
The funds re-contributed must reflect the same proportions of the tax-tree and taxable component of your total super balance. Withdrawals cannot be made from only one component of your account. Let’s explore how this works in practise.
Jane is 65 years old with $1 million in super and seeks to re-contribute funds as a non-concessional contribution to lower her taxable balance of $300k. She uses the bring-forward rule and decides to re-contribute the maximum of $360,000.
It is important to note that despite the recontribution strategy, earnings on the existing balance will continue be added to the taxable component of your super which will gradually increase overtime.
There are several considerations when planning for a re-contribution strategy which will depend on an individual’s personal circumstances. Consulting a personal financial planner may help navigate complexities that may arise.
Besides reducing tax on the lump sum death benefits of non-tax dependants, this may also reduce tax on taxable income stream payments and death benefit pensions paid to tax dependents when the deceased and beneficiary are under 60.
Leaving your superannuation to an estate
Superannuation death benefits are not automatically part of the estate of a deceased individual. In most cases the trustee of the super fund will pay the amount directly to the dependants.
The option involves directing superannuation to an estate whose death benefit will be paid to and then distributed to beneficiaries. This requires a legal personal representative (“LPR”) to administer the affairs of the deceased. Division 302 of the Income Tax Assessment Act 1997 (Cth) (ITAA97) outlines that even with the presence of a Will, the LPR determines the extent of proceeds to flow to a death benefits dependant unless you have made a Binding Death Benefit Nomination (“BDBN”) through your superfund.
A BDBN can expire after 3 years or be non-lapsing till your death. Without a BDBN, the superfund trustee has discretion to determine (in accordance with fund terms) who the amount is ultimately paid to. To ensure your funds are directed to your chosen beneficiaries, creating a BDBN that directs the amount to an estate guarantees you can capture estate tax efficiencies whilst ensuring the Will ultimately determines who benefits.
In this situation, the super fund does not pay the assessable tax directly to the ATO, rather it is the responsibility of the LPR. Once the benefit is received by the estate it will be taxed as income therefore subsequent distributions to beneficiaries do not have tax liabilities. Of course, in the presence of dependants such as minor children, the benefit will be tax-free.
In the event of adult children beneficiaries, the benefit shall still be taxed the same amount regardless of whether it is under an estate, however, the 2% Medicare levy does not apply. This may seem like a minor consideration, nevertheless the amount saved can be significant. For example, a superannuation account with $500,000 is liable for a $10,000 Medicare Levy which would be nullified if the benefit was left to an estate.
Furthermore, in an estate, the taxable component of a super death benefit does not form part of the assessable income for a beneficiary, therefore is not included in the individual’s tax return. This has benefits if the lump sum is paid to an adult child as it does not affect HECS/HELP debt repayments, family tax or low income benefits, superannuation co-contributions, or the tax considerations of Division 293 for high-income earners.
Withdraw all your funds before death
This is contentious option and involves some level of foresight on your time of death. Of course, in cases of terminal illness it is much more straightforward. Withdrawing all your superannuation and putting it into a financial institution means that it is no longer subject to the death tax. This is often done with the individual has no dependants who would receive the benefit tax free. Unless advised by an executer, tax is not paid on inherited cash, shares or property but there may be tax obligations for assets inherited – for example capital gains on dappreciated assets.
If you meet the conditions of release, withdrawing lump sums are not a taxable event if you are part of a taxed super fund. Those under 60 who wish to withdraw their funds will be subject to a 17 – 32% tax (in most circumstances) on withdrawal amounts over the ‘low-rate cap’ which is $235,000.
In the event of becoming incapacitated before death, appointing an enduring power-of-attorney during estate planning is important to they may withdraw funds on your behalf.
Estate planning can be complex. Individuals should seek tailored financial advice to optimise their retirement and ensure their beneficiaries are left with the most efficient inheritance structure.
