Feature: Death and taxes in superannuation (Part 2)

Feature: Death and taxes in superannuation (Part 2)

We hear a lot about death and taxes in superannuation...what is the current state of play?

Here we conclude last month's article on the various taxes that can apply when a fund member dies. A reminder that this information applies specifically to self managed funds but the same rules are generally applicable to most private (non-Government) superannuation funds.

>> Read Part 1 of this article from the April newsletter

Tax paid by the beneficiaries
Superannuation is divided into two parts for tax purposes: a "tax free" component and a "taxable" component. 

As the name suggests, no tax is paid on the "tax free" component regardless of the circumstances of the payment (after death or during life) and who receives it (even adult children pay no tax on the tax free component when they inherit a parent's superannuation). This component generally comes from contributions the deceased member made from their own money rather than contributions made by an employer.

The taxable component, on the other hand, is taxed under certain circumstances when someone dies. The amount – and in fact whether tax applies at all – will depend on who receives the benefit, the form in which it is paid (pension or lump sum) and sometimes the age of the deceased, the recipient or both.

"Dependant" recipients
Legislation defines certain people as "dependants" for tax purposes. This will generally be just a spouse and any minor children of the deceased. Technically there are others – such as anyone else financially dependent on the deceased – but these tend to be rare.

Dependants can receive their spouse / parent's superannuation completely tax free when it is paid as a lump sum. This is true regardless of the size of the benefit, the underlying tax components of the benefit, whether it includes insurance and the age of the deceased or beneficiaries.

Dependants can also receive the deceased's superannuation as a pension (although children can only do this for a period of time – at the latest, they will generally have to cash out their parent's superannuation as a lump sum at age 25). The tax treatment of pensions is slightly more complicated:


  • if either the deceased was (at death), or the recipient is (now), over 60 – the pension will be tax free (regardless of the underlying tax components); but
  •  otherwise, the taxable component will be taxed just like normal income with one special exception : the recipient will be able to claim a "tax offset" (equal to 15% of this taxable component) to reduce their tax.


Let's say Peter died when he and Joan were both under 60. Joan decides to take Peter's superannuation as a pension and in the first year she receives a pension of $30,000 from his balance. Peter has never put any money into superannuation other than contributions from his employer and hence the whole amount is a "taxable" component. Joan would add this $30,000 to her income from other sources (say her own pension, any salary she receives, rent or dividends from her personal assets etc.) and it would be taxed just like normal income. Let's say her total tax bill from all these sources of income was $10,000. She would get a special offset of $4,500 (15% of $30,000) that would reduce her tax bill to $5,500 ($10,000 - $4,500).

One final point to note is that there was no tax applied to "transfer" Peter's superannuation to Joan – it could simply be assigned to her new pension within the fund. This is important in that it avoids the need to actually pay out large benefits and remove wealth from the superannuation environment.

Non dependant recipients
The most common group of beneficiaries that falls into the "non dependant" category is adult, financially independent children. Equally, however, it could include other family members (nieces, grandchildren etc.) or friends who inherit superannuation via the deceased's estate.

Beneficiaries in this group can only ever receive lump sums (not pensions).

For most people in this group, the taxable component is taxed at 15% (+Medicare if applicable).

If we return to Joan and Peter, for a moment – we calculated earlier that the fund had $470,000 available to pay a death benefit to their adult children on Joan's death ($500,000 less $30,000 in capital gains tax payable by the fund). Let's say Joan is 70 at the time, the entire amount is classified as a "taxable" component and it is to be paid to Joan's estate (for distribution to their adult children). The tax paid will be:


15% x $470,000 = $70,500


(Note that Medicare doesn't apply when the benefit is paid via the estate. If it was paid to the children directly, the tax bill would be higher.)


Interestingly, note how much higher this bill is ($70,500) compared to the capital gains tax payable from the fund ($30,000). This is despite the fact that Joan's fund had very large capital gains. This is because while the tax rate on benefits sounds low at only 15% (+ Medicare if applicable), that tax is of course applied to capital. Most taxes are only applied to income or capital gains – not the capital itself.

There is one additional quirk that applies if Joan had died before reaching 65. Under these circumstances there would be a special extra part of her "taxable" component if:


  • her benefit included some insurance; and


  • the fund had historically claimed a tax deduction for its insurance premiums.


This special part of her taxable component would actually be taxed at an even higher rate – 30% (+ medicare if applicable).

The exact amount taxed at 30% depends on when the current super balance first started building up (either in this fund or a previous fund) and how many years remain until the deceased reaches 65. In a nutshell, it reduces steadily to $nil by age 65 and is at its largest when someone dies very young and/or or very soon after starting their superannuation savings. 

By way of example, if Joan had started her superannuation savings at 45 and died at 60 (ie, ¾ of the way to age 65) with no "tax free" component, roughly ¼ of her balance would be subject to this special extra tax rate.

Bear in mind, however that this extra high rate of tax doesn't apply to everyone who dies before 65. It is generally only applicable to those who die young and have insurance but no dependants. It will not apply to someone who dies young with dependants (the group most likely to have insurance) as this special component doesn't apply when the benefit is paid to dependants.

Conclusion
Passing superannuation from one spouse to another on death is often relatively straightforward with minimal tax consequences.

It is when superannuation is passed to the next generation that the differences between this and other inheritances are most apparent. While inheriting other assets does not generally impose an immediate tax cost, the fact that superannuation law requires a benefit to be paid (triggering asset sales) and then specifically imposes a tax on that payment can result in a substantial tax impost. 

There are certainly steps that can be taken to minimise both taxes but in fact the only way to completely avoid these taxes is to transfer all wealth out of superannuation whilst the parents are in pension phase and before both parents have died.


For further information about how these rules apply to you, please contact us.