Superannuation and the terminally ill

While a reflex action to terminal illness might be to claim superannuation immediately, Sarina Raffo examines a better strategy for dealing with a worst-case scenario.

Taking superannuation early is generally par for the course for someone who is terminally ill. However, it may be worthwhile stopping and thinking of better options from a financial planning perspective for your client if they are in this unfortunate and all too common predicament. 

Specifically, there are some key issues to consider:

• Access;
• Taxation;
• Estate planning; and
• Insurance proceeds.

Access

There are potentially two conditions of release available to a terminally ill client: permanent incapacity and terminal medical condition. There are some important distinctions between the two.

The terminal medical condition of release requires certification from two registered medical practitioners (including one practitioner who is a specialist on the particular injury or illness) that the person suffers from an illness or has incurred an injury that is likely to result in their death within a (certification) period that ends no more than 12 months after the date of the certification.

To satisfy the terminal medical condition requirements, the client must have a life expectancy of less than 12 months.

In contrast, a trustee of a super fund may release super benefits under the permanent incapacity condition of release if the trustee is reasonably satisfied that the individual is unlikely to engage in gainful employment for which the person is qualified.

Medical certification is not a requirement under permanent incapacity, rather, it is up to the trustee as to the standard of proof they require to enable them to be reasonably satisfied that the definition has been met.

A client who is permanently incapacitated must be unlikely to be able to work, whereas a terminally ill client can conceivably continue working (subject to capacity).

Terminal medical condition benefits cannot be rolled over within the superannuation system, although a terminal medical condition and permanent incapacity benefits may be retained in the super fund indefinitely.

Both a terminal medical condition and permanent incapacity benefit can be paid in the form of a lump sum or an income stream.

Taxation

Terminal medical condition benefits

A terminal illness lump sum benefit is paid tax-free, regardless of the recipient’s age and the underlying tax components. In addition, it is not assessable income, and it is not exempt income. 

Concessional tax treatment does not apply to a terminal medical condition income stream; any taxable component is taxed at marginal tax rates, similar to a disability income stream.

However, the 15 per cent tax offset only applies between preservation age and age 60 or if the disability super benefit definition has been met. A terminal medical condition income stream can only be commenced from the client’s existing fund (ie, the benefit cannot be rolled over to another fund).

However, a client can roll their benefit to another fund (that pays an income stream) before declaring terminal illness. Alternatively, the client can withdraw their benefit and re-contribute it to another fund (if eligible).

Permanent incapacity benefits

A lump sum disability benefit is taxed as a normal super lump sum (ie, it is paid tax-free from age 60 but may be taxable under the age of 60).

However, an additional tax-free amount may apply to lump sum benefits paid under age 60 to reflect the future period the individual would have been expected to work.

Since the formula relates to days to retirement (generally age 65), the younger the individual, the more tax-free component. Importantly, insurance proceeds are included in the lump sum benefit to which the formula is applied.

For the additional tax-free amount to be calculated, a crystallising event must take place – ie, a super lump sum must be paid, or alternatively, the benefit can be rolled over.

In addition, two legally qualified medical practitioners must certify that because of the person’s illness or injury, it is unlikely he or she will ever be gainfully employed in a capacity for which he or she is reasonably qualified because of education, experience or training.

The additional tax-free amount does not apply to a disability income stream.

For someone who is under 60, the taxable component of the income stream payments is taxed at their marginal tax rate. However, the taxable portion will be entitled to a 15 per cent tax offset, regardless of the recipient’s age. Income payments to an individual aged 60 or over are tax-free.

Estate planning

If an individual who is terminally ill or permanently disabled withdraws their benefit from super, they may distribute some money to children and grandchildren at that point. However, it may be more tax-effective to retain some or all the money in super and have it distributed as a death benefit.

If the terminally ill individual does not require the money and has tax dependent beneficiaries (eg, spouse or child under 18), it may be worth considering leaving the money in accumulation so the beneficiary can take advantage of the anti-detriment provisions, and potentially receive a larger death benefit.

The anti-detriment is essentially a refund of the 15 per cent contributions tax paid. As not all super funds pay an anti-detriment benefit, the client could roll their benefit to another fund (that pays an anti-detriment amount); this must be done before declaring terminal illness.

If benefits will be paid to a tax dependant (particularly if there are minor children) consideration could be given to retaining the benefit in super so they can have the option of taking an income stream for ongoing tax benefits.

Alternatively, the client could commence an income stream while alive, with a reversionary nomination to the surviving spouse.

Where a terminally ill individual has non-tax dependent beneficiaries, it may be preferable to take a tax-free lump sum benefit and distribute the money immediately.

Insurance proceeds

If a client receives insurance proceeds (either total and permanent disability or terminal illness), these will be added to the taxable component of their superannuation balance. This will have implications if benefits are retained in super or an income stream is commenced.

It is likely that an untaxed amount will arise upon payment of a death benefit to non-tax dependants (ie, tax of up to 31.5 per cent will apply to a portion of the death benefit).

Where an income stream is commenced, the tax components will be proportioned between taxable and tax-free components. The insurance proceeds will create a larger taxable component. This will mean more tax on a terminal medical condition or permanent incapacity income stream before age 60.

An anti-detriment amount is calculated on a lump sum death benefit to a spouse or child (of any age); however, the calculation excludes the insurance proceeds. An untaxed amount (if any) is calculated on the entire death benefit (ie, the death benefit increased to include the anti-detriment amount).

Care needs to be taken if rolling to another fund before declaring terminal illness (to take advantage of the anti-detriment) to ensure this doesn’t terminate or adversely affect the client’s insurance arrangements.

Conclusion

In the instance where a client is able to satisfy both the permanent incapacity and terminal medical condition of release, the terminal medical condition of release will provide a better tax outcome for most clients under age 60 who take a lump sum.

However, if an income stream is commenced, individuals will only qualify for the 15 per cent pension offset if they are age 55 to 59 or satisfy the disability super benefit (more likely if they pursue the permanent incapacity condition of release).

Where a client wishes to provide for dependants, retaining some or all of the benefits in super may give beneficiaries a potentially larger death benefit (where an anti-detriment is paid) or the option of taking an income stream.

If a speedy payment is required, terminal illness is generally paid more quickly than permanent incapacity due to simpler administrative processes.

Sarina Raffo is a technical services consultant at Suncorp Life.