Making death less taxing for your kids

Your death can be costly for your children. Here’s how to relieve some tax pain.

Summary: Making your children beneficiaries of your superannuation can be very costly to them upon your death if they’re adults. In all likelihood they will be up for a big tax bill on any lump sum they receive. But there are ways to relieve their financial pain, and it all comes down to careful tax planning by you before you depart.
Key take-out: A recontribution strategy, whereby funds are withdrawn by a member and then put back in as non-concessional (tax-free) contributions, is an effective way of changing the taxable components of a fund.
Key beneficiaries: SMSF trustees and superannuation accountholders. Category: Superannuation.

We all know and love superannuation as this great income stream that comes to us tax-free eventually, usually after we turn 60 or 65.

Well, most of it comes tax-free and to nearly all of us. There are a few exceptions, and there are regular (largely political) threats to it staying that way.

For example, those who have enjoyed “untaxed” funds paid into their super will have to pay tax when they receive their funds. And the former government wanted to tax pension funds with incomes greater than $100,000.

Something that is less well understood is that superannuation is not necessarily passed on tax-free to the next generation.

You could often be leaving your children with considerable tax bills when you fall off your perch. Potentially up to 31.5% of your fund could be lost in a lump sum tax as it passes through your estate.

Is it common? Yes. In fact, some of your super being lost to the tax man before being passed on is incredibly common, if not the norm. And it will happen to almost everyone who leaves super to a child over 18.

If the majority of Australians are those who die when their children are over 18, then there are some potential big tax bills ahead that will be inflicted on your children as beneficiaries.

But there are several things you can do to minimise the tax debt you leave on your death, and they require careful planning.

What are the potential issues?

Superannuation will only pass on to the next person tax-free under certain circumstances.

Most broadly, it is designed to be left to financial dependants – your spouse and underage children – tax free. However, it goes a little wider than that.

The actual definition is a “death benefits dependant”, and it is determined by the Tax Act rather than by superannuation legislation. A death benefits dependant includes:

  • Your spouse (including defacto);
  • A former spouse;
  • A child aged less than 18;
  • Those with which you have shared a interdependency relationship immediately prior to death;
  • Others who were financially dependent on you just before you died.

Adult children are the big ones missing here. And it is here where the most tax is likely to be paid. You can leave super directly to your adult children (that is, not through your estate), but they will most likely have to pay tax on it.

Essentially, if you are leaving everything to a death benefits dependant, they will get it all tax-free.

However, if it is being left to someone who is not considered to be a death benefits dependant, some tax is likely.

Table 1: Tax treatment for non-dependants

Tax treatment

Beneficiary (tax definition)

Tax-free component

Taxable component

Element taxed

Element untaxed

Death benefits dependant

Non assessable non-exempt income

Non-assessable non-exempt income

Non-assessable non-exempt income

Non-dependant

Non assessable non-exempt income

15%*

30%*

* Plus Medicare Levy

Important note: We are not dealing today with the tax treatment of death benefit income streams, which have a separate taxation treatment. Pensions can also only be paid to superannuation dependants (Superannuation Industry Supervision Act dependants), so not adult children, for example. I will deal with this topic on another day.

Imagine then that you’ve worked most of your life in the public service, under an untaxed defined benefit scheme. If received as a lump sum, your children are going to lose up to 31.5% in tax of the amount payable. A $1 million super fund, in this example, could lose up to $315,000 to the ATO.

Obviously, you want as much as possible to be labelled as the “tax-free component” in your super fund. The main way of getting higher tax-free portions of your super fund is through straight non-concessional contributions, which are after-tax contributions.

How to lessen the tax damage?

One way of reducing the tax damage is via a recontribution strategy, which is not something that can be done after you die.

A recontribution strategy is where money is withdrawn from super and then recontributed – you need to have met a condition of release to do this (see The great super release).

Why would you do that? Because you change the tax elements that make up your super fund – the recontributed funds would return to super as non-concessional (tax-free) contributions.

How does this happen? Let’s take someone with $600,000 in super. He is 60, divorced and looking to start a TTR (transition to retirement) pension, having previously met a condition of release. He does not wish to leave money to his previous partner and wishes instead to leave it to his adult children. He has previously made some non-concessional contributions to super and now finds that half of his super fund is taxable. That is, if he were to die now and successfully leave this money to his adult children (by way of, say, a binding nomination), the member’s children would be paying tax on half of the benefits they receive.

How would a recontribution strategy change that? The tax-free threshold for the 2014 financial year is $180,000, so our member could withdraw enough to use up that sum. Any super taken has to be in proportion, so he can take a total of $360,000 from his super, being $180,000 from both the taxable and tax-free components.

This $360,000 amount would go back into super as non-concessional contributions, so he would need to be aware of his non-concessional contribution limits and the pull-forward rule ($450,000 over a three-year period). If his previous contributions were recent, he would need to take that into consideration before implementing this strategy.

Table 2: Changing taxable components

Changing tax components via a recontribution strategy

Tax-free component

Taxable component

Initial balance

$300,000

$300,000

Withdrawal

$180,000

$180,000

Balance in fund

$120,000

$120,000

Add recontributions

$360,000

$0

Balance after recontributions

$480,000

$120,000

Prior to the recontribution, half of the member’s $600,000 super fund would have been taxed on leaving the money to his children. Now, just $120,000, or 20%, would be taxable if leaving it to his adult children.

Before, the tax would have been 16.5% of $300,000 ($49,500), while now his death would attract a tax bill of 16.5% of $120,000 ($19,800).

(A second use for a recontribution strategy – reducing tax on income streams taken prior to turning 60 – was discussed in this column, Give back your super pension).

Recontribution strategies certainly aren’t dead, and they need to be implemented before you are.


The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.

Bruce Brammall is director of Castellan Financial Consulting and the author of Debt Man Walking. E: bruce@castellanfinancial.com.au
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  • SMSF assets grew by 4.8% to $531.5 billion in the September quarter, statistics from the Australian Prudential Regulation Authority (APRA) show. This put asset growth for the year to September 30 at 16.8%, with the number of SMSF funds lifting by 6.5% to 517,000 over the same period. Chief executive of the SPAA, Andrea Slattery, expects these trends to continue as the increased contribution caps for older Australians take effect and as investment markets generate stronger returns.
  • People wishing to create their own SMSF should have at least $200,000 in their account, according to a survey by The Metlife/Super Review Super Outlook. The majority of respondents, who were surveyed during the recent Association of Superannuation Funds of Australia conference in Perth, said it should be higher, with 29.5% indicating $350,000 and 30.6% saying $500,000. 19.3% of respondents believed at least $200,000 was appropriate.
  • The Australian Institute of Superannuation Trustees (AIST) has called for the Federal Government’s financial system review to examine the impact of SMSF schemes on taxpayers, according to media reports. Industry funds are warning of the systematic risks of self-managed funds and are attempting to discourage the government catering to retail investors and SMSFs as funding sources because of the difficulty in operating and regulating the secondary markets.