Here's a retirement planning tip: don't die until you've spent all your super.
I'm serious. Superannuation death benefits can be a super headache unless you have the convenience of a surviving spouse to leave your money to. The treatment of death benefits is always arcane and often arbitrary, as evidenced by the latest issue to have advisers and industry groups spitting into their morning weeties.
Last week, the Tax Office issued a draft ruling stating, in very simple terms, that when you die, you're no longer eligible to receive a pension.
On the face of it, that's a sublime case of stating the obvious. But it has got sections of the industry screaming blue murder, while others are scratching their heads wondering what all the fuss is about.
The thing is that, as any retiree knows, taking a super pension is a good thing. If you're over 60, income from a super pension is tax-free. Even better, your pension fund (or the portion of a super fund that is used to provide your pension) is not taxed on its earnings, unlike ordinary super money, which is taxed at up to 15 per cent.
That is particularly attractive if you have your own self-managed super fund as any capital gains you incurred while you were saving for retirement become effectively tax-free once you convert to a pension.
The gains are still there but, as the pension fund is exempt from tax, you don't have to worry about what, potentially, could have been a sizeable tax liability.
So far, so good. But what happens if you die before selling those assets? If the pension reverts to your spouse or child under 18, it's no problem as an eligible pension is still being paid from the fund.
But if you don't have a handy spouse or minor to leave the benefit to, that lovely tax-free pension you were encouraged to set up no longer exists. If your super is to be paid to someone else - an adult child, for instance - it becomes a lump sum and that capital gains tax liability you thought you'd abolished comes back to life.
When the fund sells the assets to pay out your beneficiaries, it could be facing a substantial tax bill.
The Self-Managed Super Fund Professionals Association (SPAA) reckons this will hit self-managed funds particularly hard.
If you're in a big public fund, it may not have to sell assets to pay out your death benefit.
But many self-managed funds hold assets such as shares and property, often owned for decades, and if they haven't made provision for tax, SPAA says the capital gains tax bill could be a substantial part of the account balance.
SPAA says it has always worked on the assumption that the pension does not cease until the death benefit is paid, which would allow the assets to be sold without incurring tax. It will be making a submission to the Tax Office that this should be in the final ruling.
But others in the industry say the Tax Office's position has long been clear and its latest ruling changes nothing.
The head of technical at Super IQ, Kate Anderson, points to a 2004 interpretive decision by the Tax Office, ATO ID 2004/688, which concluded that the tax exemption for pension assets ceased when the pensioner died unless arrangements were in place for someone else to receive the pension. She says she has always worked on this interpretation - though, clearly, many accountants and advisers were unaware of it or disagreed with the Tax Office's view.
Part of the problem may be that most pensions still revert to the surviving spouse and it is not until that spouse dies that tax will become an issue.
Anderson says strategies can be used to minimise the potential tax bite. These include selling assets in retirement and replacing them with new ones, effectively refreshing the cost base of the fund's assets for tax purposes and recontribution strategies, whereby assets are sold to fund lump-sum withdrawals and the member then uses the money to make a new contribution to fund new asset purchases.
However, recontributions can be tricky as the member will still need to be eligible to contribute and will be limited in how much they can put in by contribution caps.
The tax treatment of death benefits is also complicated by the fact that "non-dependants", such as adult children, are taxed on receipt of the benefit, whereas dependants are not.
So, again, if you don't have that handy spouse or minor to pass your super on to, tax could apply both within the fund and when the money is paid out to your beneficiaries.
The super industry has long argued that all super death benefits should be taxed in the same manner. It seems unfair and arbitrary that some beneficiaries pay tax while others do not.
The latest draft ruling merely provides further meat for the grill.
From a retiree's viewpoint, it all adds up to a complicated headache. Even if you intend for your spouse to continue your pension, what happens when he or she dies and your benefits go to someone else?
There are basically three options unless the rules are simplified and changed to treat all beneficiaries equally.
Get advice and plan well ahead
Let your beneficiaries worry about any tax bill
Consult a fortune teller for your use-by date and make sure you spend the last dollar of your super the day before. If only we could.
Frequently Asked Questions about this Article…
What did the ATO draft ruling say about superannuation pensions and death?
The Tax Office (ATO) draft ruling says that when a pension member dies they are no longer eligible to receive a pension, which means the tax-exempt status for the pension portion can cease on death unless arrangements are in place for someone else to receive the pension. The article notes this is consistent with an earlier ATO interpretive decision (ATO ID 2004/688).
How can capital gains tax (CGT) 'come back to life' for my super when I die?
If your pension stops on death and the super benefit is paid as a lump sum (for example to an adult child), the fund may need to sell assets to pay that lump sum. Because the pension exemption can cease, capital gains tax that was effectively sheltered while you were in pension phase can apply when those assets are sold, potentially creating a substantial tax bill for the fund or beneficiaries.
Why are self-managed super funds (SMSFs) particularly vulnerable to death-benefit capital gains tax?
The Self-Managed Super Fund Professionals Association (SPAA) warns SMSFs are often invested in long-held assets like shares and property. If those assets must be sold to pay a death benefit and the pension exemption has ceased, the resulting CGT could be a large portion of the account balance. Large public funds may avoid selling assets, but many SMSFs would face this risk.
Who counts as a dependant for super death benefits and how does that affect tax?
According to the article, dependants (for example a surviving spouse or a child under 18) generally receive eligible pensions or benefits that are not taxed. Non-dependants, such as adult children, are taxed on receipt of the benefit. That distinction matters because payments to non-dependants can trigger tax both inside the fund (when assets are sold) and when the money is paid out.
Are there practical strategies to reduce the potential CGT hit on death benefits?
The article mentions a few strategies industry experts suggest: selling assets in retirement and buying replacement assets to refresh the fund’s cost base, and recontribution strategies where assets are sold to fund a lump-sum withdrawal and the member recontributes funds to buy new assets. However, recontributions are subject to contribution caps and eligibility rules, so they can be complex.
Does the ATO draft ruling create a new rule or just clarify existing law?
Industry views are split. Some say the draft ruling simply restates an existing ATO position (pointing to ATO ID 2004/688, which concluded the pension exemption can cease on the member’s death), while others — including SPAA — were surprised and are pressing for clarification. The article notes some advisers had been unaware of or disagreed with the ATO’s long-standing interpretation.
How could tax apply both inside the super fund and when beneficiaries get the money?
Tax can apply inside the fund if assets must be sold to pay a death benefit and the pension exemption no longer applies, generating a capital gains tax liability for the fund. Separately, when the benefit is paid to a non-dependant beneficiary (for example an adult child), that person may be taxed on receipt of the benefit — so tax can be triggered at both stages.
What should everyday investors do now about the possibility of CGT on super death benefits?
The article suggests practical steps: get advice and plan well ahead (review beneficiaries, consider pension reversion arrangements, and assess asset mix and tax implications in retirement). It also warns that options like recontributions and selling assets have limits and trade-offs, so early professional planning is important to reduce the risk of an unexpected tax bill for your heirs.
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