Tax may be payable on your Super Benefit on Death

Where part or all of your Super Benefit has a Taxable Component (see below) and you intend to leave your Super Benefit on death to someone other than permitted beneficiaries detailed below then the recipient will be taxed on the Taxable Component at 16.50%

-Spouse
-Child under 18
-Any person financially dependant on you
-Any person with whom you have an interdependency relationship.

For further details of "Permitted Beneficiaries" click here.

Example:

Assume Barney who is 61 years of age, has $450,000 in super, made up of a Taxable Component of $400,000 and a Tax Free Component of $50,000.  On Barney's death his Super Benefit is received by his son Barney Junior who is aged 30 and is not a Financial Dependent.  Barney's son will not be taxed on the Tax Free Component of $50,000 but will be taxed at 16.50% on the Taxable Component of $400,000.  This equates to a tax liability of $66,000.  Ouch!

If your Super Benefit has no Taxable Component and is made up totally of a Tax Free Component, or you leave your Super Benefit to a Tax Free Beneficiary (eg your Spouse, a child under 18, anyone financially dependant on you or with who you have an interdependency relationship), then your entire Super Benefit will be paid tax free to the nominated beneficiaries.  Where this is not the case, and you find yourself in a similar situation to the example above, the following strategies may assist in reducing the tax burden on the Beneficiaries receiving your Super Benefit on death.

Strategy 1 - Leave your Super Benefit to a Tax Free Beneficiary

Essentially you can leave your Super Benefit to any person (either directly or via your estate) when you execute a Binding Death Nomination.  It is however important to recognize that the way the legislation is drafted there are substantially different tax outcomes depending on which beneficiary ultimately receives your Super Benefit.  Currently the only beneficiaries that can receive your Super benefit tax free are your Spouse, a child under 18, anyone financially dependant on or with whom you have an interdependency relationship.  Accordingly leaving your Super Benefit to any other person, such as a friend or child over 18 (who is not financially dependent on you), may expose them to tax on the benefit they receive at up to 16.50% on the Taxable Component of your Super Benefit. 

By way of background, your Super Benefit is made up of a Taxable Component (usually from Concessional Contributions made to the SMSF by your Employer) and a Tax Free Component (usually from Non Concessional Contributions made to you from after tax income).  Where you have a Taxable Component and leave it to beneficiaries other than your Spouse, a child under 18 anyone financially dependant on you or with who you have an interdependency relationship, that beneficiary will pay tax at 16.50% on the Taxable Component of your Super Benefit.  Where your Super Benefit is made up totally of a Tax Free Component it will make no difference who you leave your Super Benefit to as it will be Tax Free to the recipient.

Where you have a Taxable Component and you wish to leave your Super Benefit to your Spouse, a child under 18, anyone financially dependant on you or with whom you have an interdependency relationship, there are no tax issues as those beneficiaries will receive the benefit tax free.  However where you have a Taxable Component and you wish to leave your Super Benefit to someone other than these beneficiaries, such as a Child over 18 who is not financially dependent on you or a friend, consideration can be given to first leaving the Super Benefit to a tax free beneficiary such as your Spouse, who can in turn pass the Super Benefit to the child or friend tax free!  Obviously there is an element of trust that the Super Benefit will be passed on, but in a family relationship this may not be a great concern.

Example:

Barney has a Super Benefit made up of a Taxable Component (usually from Concessional Contributions made to the SMSF by your Employer) of $400,000 and a Tax Free Component (usually from Non Concessional Contributions made by you from after tax income) of $100,000.  This means Barney's Taxable percentage is 80% ($400,000 / $500,000) and his Tax Free percentage is 20% ($100,000 / $500,000).  Barney has executed a Binding Death Nomination, nominating his son, Barney Junior, who is 30 (and NOT Financially Dependent on him) to receive his Super Benefit on death.  This means that 80% of the payment to Barney's son on his death will be taxable at 16.50%.  This equates to a tax bill of $66,000 (ie. 16.50% x $400,000).  If Barney leaves the entire Super Benefit to his Spouse, they will receive the benefit tax free.  The Spouse can in turn pass the Super Benefit on to Barney Junior, tax free!  A saving of $66,000!

Strategy 2 - Avoiding Capital Gains Tax on Death ("The Elephant in the Room")

Paying a Benefit on Death as a Lump Sum may still cause tax issues even if made to a Tax Free Beneficiary as detailed in Strategy 1.  This unknown problem in the elephant in the room and must be carefully planned for.   The problem involves the process of paying a Lump Sum Benefit to a Beneficiary.  When a Member dies his Super Benefit will automatically revert back to Accumulation Phase even if he is receiving a Pension at the time of death.  This is because strictly speaking, the SMSF cannot continue paying a Pension when the Member dies.  This means that the Tax Free Status of the Members Benefit also ceases.  This can have disastrous tax benefits for the SMSF who may be liable to tax on any unrealised profits built up in the Members Account.

Example:

Barney is 80 years of age and has a $1,000,000 Super Benefit.  His benefit is made up totally of Shares that have been acquired over the years.  The Shares were purchased for a consideration of $600,000 and Barney is sitting on an unrealised capital gain of $400,000.  If Barney sells the Shares whilst he is alive and in Pension mode then the capital gain will be tax free.  Barney however decides not to sell the Shares and is very comfortable with the income that the Shares provide him.  Barney's Spouse has recently passed away and Barney has specified his son, Barney Junior, to receive his Super Benefit on death.  Barney Junior is 55 and is not dependant on Barney.  The Super Benefit will be paid to him as a Lump Sum on his father's death.  Soon after Barney passes away.  The SMSF duly sells up the Shares and pays Barney Junior his Lump Sum inheritance pursuant to the Binding Death Nomination. 

There is now a problem however!

On Barney's death his Super Benefit automatically reverted back to Pension mode.  So when the Shares were sold, the unrealised capital gain was triggered of $400,000.  Given that the shares were owned for over 12 months the capital gain was taxed at 10% resulting is a $40,000 tax liability!  This tax is in addition to the any Lump Sum Tax payable on the Taxable Component of Barney's Super Benefit as detailed above.  It doesn't even matter if the Shares were not sold and were simply transferred directly to Barney Junior.  The same tax result would occur.  This unknown tax is the elephant in the room and must be carefully planned for. 

Planning Option 1:  Leave your Super Benefit as a Pension instead of a Lump Sum

One option to avoid the tax liability above is to leave the Super Benefit on death as a Pension rather than a Lump Sum.  You can only nominate certain Beneficiaries to receive your Super Benefit as a Pension however.  These Beneficiaries include a Spouse, a child under 18, anyone financially dependant on you or with whom you have an interdependency relationship. 

Example Continued:

In the above example if Barney had left his Super Benefit to his Spouse as a Pension this could have avoided the capital gains tax liability completely.  That is on receipt of the Super Benefit as a Pension, Barney's Spouse has the option of selling the Shares.  Given she is in Pension phase, the capital gain will be completely tax free!  Barney's Spouse could in turn pay a Lump Sum Tax Free to Barney Junior, tax free.  This Strategy would result in a Tax Saving of $40,000!  Obviously this strategy is only possible if you can leave your Super Benefit to a Beneficiary who can receive a Pension on death.

Planning Option 2:  "Freshen Up" Capital Gains

An alternative way to reduce or eliminate the capital gains tax liability of the sale of the Shares where a Lump Sum Benefit is to be paid to a Beneficiary is to "freshen up" the capital gain prior to death.  This simply means that prior to death any Shares or other assets where there is a large capital gain can be sold whilst the Member is in Pension Phase and where required can be bought back at a later time.

Example Continued:

In the above example Barney could sell his $1,000,000 share portfolio and over time repurchase the shares again.  The capital gain of $400,000 in this case would be tax free as Barney is still in Pension Phase.  On Barney's death the Shares would have a new cost price of $1,000,000 meaning that his Beneficiaries would pay no capital gains tax on the sale of the Shares.  This strategy could be continuously employed whilst Barney is alive as the Shares begin to increase in value again.  This Strategy would result in a Tax Saving of $40,000! 

Strategy 3 - Withdraw Super Benefit as a Lump Sum prior to Death

No tax is payable on your Super withdrawals when you are over 60.  This means that to the extent that you are over 60 you can simply withdraw monies prior to death, and in turn leave those monies to Non Dependants in your "Will" tax free.  The obvious problem with this strategy is that you do not know when you will die and for a period of time your assets will sit outside the Super environment.  Taking money out of the Super Environment too early will result in obvious tax benefits being lost which is an obvious disadvantage of this Strategy.

Example Continued:

In the above example Barney can transfer his $1,000,000 share portfolio in his SMSF to his own personal name tax free.  He can in turn "Will" the shares to Barney Junior tax free!  This Strategy would result in a Tax Saving of $40,000!  The obvious problem with this strategy is that if Barney lives for many more years then he will be subject to tax on the income and capital gains derived on his assets in his own name, whereas leaving his assets in his SMSF would avoid all tax if Barney is in Pension phase.  The timing of this strategy is hence vital but impossible as it essentially involves a "prediction" of when a person is likely to die.

Strategy 4- Recontribution Strategy

A strategy to minimise the tax payable on the receipt of a Death Benefit, a Member may consider boosting the Tax Free component of their Benefit by using a "Recontribution Strategy.  In order to undertake a "Recontribution Strategy" the Member must have first met a condition of release to withdraw their Super Benefits (eg they have retired or turned 65) plus they must be eligible to contribute into their SMSF. 

A Recontribution Strategy will involve the retired Member withdrawing all or part of their Taxable Component after the age of 60 (when super withdrawals are tax free) from their SMSF Bank Account and transferring it to their personal Bank Account.  The retired Member will in turn "recontribute" the withdrawal back into the SMSF Bank Account in the next day or later.  The "recontribution" must be within the contributions limits allowed.  It is also important to understand that you cannot simply withdraw only the Taxable Component of your Super Benefit.  Your Super Benefit must be withdrawn in the same proportion as the Tax Free and Taxable Components of the Member's Super Benefit in the in the SMSF.
 
The primary objective of this popular strategy is to convert all or part of a Member's Taxable Component into a Tax Free Component.  It is important to understand that the Member's Super Benefit must be physically transferred from the SMSF Bank Account to a personal Bank Account.  The amount must in turn be transferred back to the SMSF Bank Account as a Non Concessional Contribution.  An accounting entry is not sufficient.  There must be a debit and corresponding credit within the SMSF Bank Account.  A "Recontribution Strategy" can be undertaken when the Member is either in Accumulation or Pension phase

Example: 

Barney is 61 years of age and has a Super Benefit of $450,000 made up of a Taxable Component of $400,000 and a Tax Free Component of $50,000.  On Barney's death his Super Benefit is received by his son Barney Junior who is aged 30 and is not a Financial Dependent.  Barney's son will not be taxed on the Tax Free Component of $50,000 but will be taxed at 16.50% on the Taxable Component of $400,000.  This equates to a tax liability of $66,000.  Ouch!

To minimise the impact of this tax liability prior to his death, Barney decides to access all his Super Benefit of $450,000 by transferring it his personal bank account.  The withdrawal is totally Tax Free as Barney is over 60.  Barney in turn "recontributes" his Super Benefit back into his SMSF the next day.  Under the "3 Year Bring Forward Rule" Barney is able to make a one off contribution of up to $450,000, so contributing his $450,000 back into the SMSF causes no tax issues. 

The above "Recontribution Strategy" now means that Barney's Super Benefit is totally made up of a Tax Free Component as the contributions have been sourced totally from his one off Non Concessional Contribution under this Strategy.  On Barney's death his Super Benefit is received by his son Barney Junior who is aged 30 and is not a Financial Dependent.  Barney's son will not be taxed on the Tax Free Component of $450,000.  Given there is no Taxable Component, the Super Benefit is now passed to Barney Junior completely tax free!  A savings of $66,000 in tax!

Strategy 5 - Freeze the Tax Free Component of your SMSF

Your Super Benefit is comprised of a Taxable Component" and a "Tax Free Component".   Each Component is expressed as a percentage and is constantly changing as your Super Benefit changes in value. 

Example:

For example assume you make a $450,000 Non Concessional Contribution into your SMSF and this is the total of your Super Benefit in the SMSF.  In this case your Tax Free Component will be 100% and your Taxable Component will be 0%.  Now assume that over the next 2 years your Super Benefit increases to $750,000 due to SMSF income and capital growth.  The increase in the Super Benefit will be allocated to the "Taxed Component" meaning your Tax Free percentage decreases to 60% (ie $450,000 / $750,000) and your Taxable Component increases to 40% (ie $300,000 / $750,000).

It is possible however to "freeze" these components by simply commencing a Simple Account Based Pension or Transition to Retirement Pension (assuming you were eligible to do so).  In the above example if you commenced a Pension on the day (or soon after) the $450,000 Non Concessional contribution is made, your Tax Free Component would be "frozen" at 100%.  This means that on your Death there will be no "Taxable Component" if your Benefit is left to a Non Dependant.  This is the case even if your SMSF increases in value to $750,000 as in the previous example.  The Strategy here is simple.  To minimise your "Taxable Component" start your Pension as soon as possible.

Strategy 6 - Leave your Super Benefit as a Pension instead of a Lump Sum

Executing a Binding Death Nomination to pay a Pension instead of a Lump Sum to a nominated beneficiary has some specific advantages over paying a Lump Sum, namely:

-Your Super Benefit will not leave the super environment on your death.  This is very important because if it does get paid out as a lump sum, the Beneficiary may not be able to contribute it back into super given the Contribution Limits that apply.

-Avoid Capital Gains Tax as detailed in Strategy 2 above.

-All earnings and investment growth will continue to be tax free.  If paid out as a lump sum and invested in the Beneficiaries name they will be taxed on the income and growth on the benefit received.

-Importantly even if left as a Pension, the Beneficiary of the Pension will be able to cash up the benefit in full or in part as required.  The tax implications of accessing a Pension as a Lump Sum will be the same as if the Super Benefit was received as a lump sum in the first instance.