Superannuation Death Tax

It’s generally well known that Australia doesn’t levy any form of tax on inherited estates. It is one of the few OECD countries not to do so.

There is one exception, however. Superannuation.

Certain beneficiaries of a superannuation payout can often pay 17% tax upon some of the funds that they receive.

This article reviews the scenarios in which someone may pay this tax and ways it can be minimised prior to passing away.

Superannuation Elements

Each person’s super fund is composed of different components, each with distinct tax implications when passed on to beneficiaries. Often you will not even see the percentages of each component on your annual statement, you may need to call up and request it from the fund itself.

There are three different components, but only the first two being relevant for most people:

• Tax-Free Component
  The tax-free portion is typically made up of non-concessional contributions (after-tax contributions), meaning it consists of money already taxed at an individual’s marginal rate before entering super.
  • Tax Implications for Beneficiaries: The tax-free component is fully exempt from tax for any beneficiary, whether they’re a dependant (such as a spouse or child under 18) or a non-dependent (e.g., an adult child).
• Taxable Component – Taxed Element
  This part of the super balance generally includes pre-tax (concessional) contributions like employer contributions, salary sacrifice amounts, and deductible personal contributions. These contributions are taxed at 15% upon entry into super but remain classified as “taxed” upon distribution.
  • Tax Implications for Beneficiaries:
    • Dependant Beneficiaries: For dependant beneficiaries, the taxed element is exempt from further tax, making it a tax-free distribution. A dependant is generally going to be the spouse of the deceased or a child under the age of 18. Other dependant beneficiaries can be found here.
    • Non-Dependant Beneficiaries: For non-dependants, such as adult children, the taxed element is subject to a 15% tax rate plus the Medicare levy, resulting in a total effective tax rate of 17% on this portion.
• Taxable Component – Untaxed Element
  The untaxed element arises primarily in certain public sector funds or specific defined benefit schemes where contributions or growth within the fund have not been taxed at all.
  • Tax Implications for Beneficiaries:
    • Dependant Beneficiaries: This component may be eligible for concessional treatment or be tax-free, depending on the structure of the fund and beneficiary type.
    • Non-Dependant Beneficiaries: For non-dependents, the untaxed element attracts a higher tax rate of 30% plus the Medicare levy, totalling an effective 32% tax rate on this portion. This higher rate reflects that no tax has yet been paid on this component within the super fund.

Naturally, the vast majority of people’s superannuation balance is composed primarily of employer contributions, resulting in a taxable-taxed component forming most, if not all, of the average person’s super balance. This means a 17% tax rate will likely apply to any superannuation left to adult children or other non-dependent beneficiaries.

Some may not worry about this issue as the mere existence of a tax means that their inheritors are at least receiving something. Others may wish to minimise this tax in any way possible.

Strategies to Minimise

Withdrawing before death

The easiest way to minimise this tax will simply be to withdraw all your funds from your super just prior to your death. Lump-sum withdrawals for a retiree are completely tax free, even if your super is all taxable-taxed component. Different rules apply for untaxed, but this is very rare for anyone to have this.

This strategy even has a rather morbid name, deathbed withdrawals. In theory, this should then result in no tax payable to beneficiaries as the funds will no longer be considered a superannuation asset and will simply pass via the estate as if it were normal money.

However, this strategy was very recently tested in court. The case highlights an issue where a withdrawal request is placed prior to death, but the death occurs before the monies are actually paid to the deceased. In this case, the funds still in the super system at death were still considered super assets and thus would need to be taxed appropriately.

Withdrawing all your funds before death also has the added issue of potentially interfering with other estate planning provisions made in your will. Removing assets from super will negate any binding nominations made within the fund.

Perceived issues pertaining to elder abuse may enter into a strategy such as this, along with the general irreverence of getting financial documents signed, rather than spending time with family in one’s final moments.

Lucky there is another strategy.

Re-Contribution Strategy

Another way to reduce tax for beneficiaries is to convert your taxable-taxed component into a tax-free component. To do this, you need to make non-concessional contributions – the type you don’t claim a tax deduction for.

Essentially, a recontribution strategy involves withdrawing from your super and then contributing it back in as a non-concessional contribution, converting what is likely mostly taxable-taxed component into tax-free. Here’s how it works in practice:

1. Withdraw Funds: Individuals over preservation age who have met a condition of release, such as retirement, can withdraw a portion of their super balance without tax implications.
2. Re-Contribute as Non-Concessional Contributions: The withdrawn amount can then be re-contributed into the super fund under the non-concessional contributions cap, effectively converting these funds into a tax-free component.

A recontribution strategy can be done multiple times however there are limits on how often it can be done, until what age, and the amount allowed.

• Contribution Caps: The non-concessional contributions cap is currently $120,000 per financial year. Additionally, Individuals under age 75 may be eligible to use the “bring-forward rule,” allowing them to make up to three years’ worth of contributions ($360,000) in a single year. You would then need to wait 3 years to be able to do the strategy again.
• Age Limit: Individuals aged under 75 can make non-concessional contributions without meeting any work test. Contributions are not allowed for those over age 75.
• Total Superannuation Balance (TSB): The TSB is the total value of an individual’s superannuation assets at the end of each financial year. If a person’s TSB exceeds $1.9 million, they are no longer eligible to make non-concessional contributions.

One issue with converting funds to a tax-free component is that when you draw funds out (as a pension), you cannot select which component the withdrawals come from—they are instead taken proportionally from each component. This can reduce the effectiveness of the tax-free conversion.

To address this, some may elect to maintain two separate superannuation accounts. One account holds all the recontributed funds, which should be 100% tax-free component. The other holds the remainder of retirement savings and is drawn from first to fulfill retirement cashflow needs.

This setup effectively quarantines the tax-free component into a fund that doesn’t need to be drawn upon immediately (if kept in accumulation phase) or can be accessed minimally (if in pension phase). This will maintain the benefit of the recontribution strategy throughout the drawdown phase of retirement, hopefully leading to a much lesser amount of tax payable by any eventual beneficiaries.

Summary

There is a very good reason why superannuation is generally taxable when inherited. It is because super was never considered to be a vessel for building an inheritance in a tax advantaged environment.

The sole purpose of super is to provide retirement benefits to its members. Its tax-advantaged status is that way in order to incentivise and maximise people’s savings for retirement, not to have these tax benefits passed on to a next generation. With that said, it’s only natural for people to wish to minimise any potential tax if it’s possible within the law.

For those considering a recontribution strategy, it’s important to remember that the benefits will be for beneficiaries, not the super owner themselves. The strategy may involve additional fees, especially if an extra account is required, and may use up non-concessional cap space that could otherwise be used to boost super savings.

Given the complexities, you should consult with an appropriately qualified professional before implementing a recontribution strategy. The interconnected rules around withdrawing and contributing to super can be intricate, and one misstep may impact your financial position significantly.