It is generally well understood that superannuation benefits do not automatically form part of an individual’s estate upon death, and that relevant superannuation regulations compel cashing of the member’s benefits as soon as practicable after death.
Upon death, a member’s benefit may generally only be paid directly from a super fund to a beneficiary who is a dependant under super law and/or their Legal Personal Representative (LPR) (ie the executor of their estate).
Under the Superannuation Industry (Supervision) Act 1993, dependants eligible to receive a death benefit directly from super (SIS dependants) include:
- a spouse (including de facto);
- a child of any age;
- any other person who was financially dependent on the deceased just before he or she died; and
- any other person with whom the deceased was in an interdependency relationship just before he or she died.
An individual will need to nominate the executor of their estate (ie LPR) and make the necessary arrangements in their will if he/she:
- does not have SIS dependants;
- is uncertain whether a beneficiary will qualify as a SIS dependant (eg financial or interdependency status is contentious); or
- wishes to direct their super death benefits to someone other than a SIS dependant (eg a non-financially dependent parent or sibling).
Where the intended beneficiary is a SIS dependant, deciding whether the beneficiary/ies or the estate should be nominated should involve consideration of the following factors:
- whether the beneficiary is eligible to commence a death benefit income stream – and if so, the advantages and disadvantages of this option;
- taxation – both on the initial receipt of the benefit and the subsequent investment of the proceeds;
- social security implications; and
- asset protection issues.
Form of payment
Super regulations govern the form in which a death benefit can be paid – that is, either lump sum and/or income stream.
However, only the following SIS dependants are eligible to receive a death benefit income stream:
- a spouse;
- a child;
- a person financially dependent on the deceased; and
- a person who was in an interdependency relationship with the deceased.
Where the beneficiary is a child of the deceased, an income stream is only possible if the child is:
- under age 18;
- between ages 18 and 25 and financially dependent on the deceased; or
- permanently disabled.
Further, the death benefit income stream must be cashed out by the time the child reaches age 25 unless the child has a disability.
Death benefit income streams can be attractive for a number of reasons, including:
- tax concessions on pension payments and earnings (subject to compliance with the pension transfer balance cap);
- social security advantages of extending the ‘grandfathered’ income test treatment of certain account-based pensions;
- avoiding contribution cap limitations that would otherwise apply if a death benefit was paid as a lump sum and subsequently recontributed to super (and possible preservation issues); and
- in the self-managed super fund context, providing an opportunity to retain certain assets within the fund, effectively passing control of the asset to certain beneficiaries while continuing to hold it in a tax friendly environment.
Should an individual wish to preserve the opportunity for an eligible beneficiary to receive a death benefit income stream, the beneficiary must be nominated directly.
Otherwise, if the payment is directed to the estate, the ability to commence a death benefit income stream is lost.
Pension transfer balance cap
The introduction of the $1.6 million transfer balance cap (TBC) on 1 July, 2017 adds a further consideration.
The TBC effectively limits the total amount of superannuation benefits that a person can transfer into a retirement phase income stream to benefit from tax-free earnings on the assets backing the income stream.
Importantly though, the value of a death benefit income stream will also be counted towards the beneficiary’s TBC.
Therefore, consideration must be given to the beneficiary’s TBC when nominating them directly, as a less than desirable tax and asset protection outcome may result if the beneficiary is left with no choice but to cash out part or all of the death benefit due to the TBC limit.
While superannuation law sets out who a death benefit may be paid to, taxation law sets out how the benefits will be taxed.
For tax purposes, a death benefit dependant (tax dependant) includes:
- a spouse;
- a former spouse;
- a child under age 18;
- a person financially dependent on the deceased;
- a person in an interdependency relationship with the deceased; and
- a person who receives a super lump sum because of the death of another person where the deceased died in the line of duty (eg military or police).
A lump sum super death benefit paid to a tax dependant, regardless of whether the payment is received directly from the fund or as a distribution from the estate, is tax-free.
Where death benefits are intended for multiple tax-dependant beneficiaries with varying personal marginal tax rates, it may be advantageous to direct the payment to the estate in order to provide capital to a testamentary trust.
The income splitting ability of testamentary trusts can help to provide an overall tax saving for the deceased/beneficiary’s family.
Beneficiaries who are non-tax dependants are subject to paying tax on super death benefits, to the extent that the payment contains taxable component.
However, a point of difference between a non-tax dependant beneficiary receiving the death benefit directly from the super fund and as an estate distribution is that the Medicare levy of two per cent will not apply to a death benefit that is paid via the estate.
Hence, paying a lump sum death benefit via the estate can provide the beneficiary with a two per cent tax saving.
Further, the taxable component of a lump sum death benefit paid directly from a super fund to a non-tax dependant is included in the beneficiary’s assessable income for the financial year in which the payment is received.
This can have indirect consequences on the beneficiary’s access to certain superannuation concessions, tax offsets, and social security entitlements.
Another significant point of difference is that the rates of 15 per cent and 30 per cent applicable to the taxed and untaxed elements respectively are the maximum tax rates payable.
If the deceased estate does not have a significant amount of other income in the financial year, then the actual tax rate applicable may be lower, particularly given that the deceased estate trustee has access to adult marginal tax rates including the tax-free threshold.
A payment of a death benefit made directly to a beneficiary in most cases will be received sooner than if made via the estate.
By bypassing the estate, the payment of the death benefit can avoid potential delays in the estate administration process.
Risk of challenges to the estate
While an individual can choose to gift their assets upon death to whomever he or she wishes, the law recognises that some individuals also have a moral obligation to provide for certain people.
As such, certain classes of people can make a claim against the estate.
Importantly, it is only assets in the estate that may be brought to satisfy family provision claims (subject to notional estate provisions in NSW).
This means that in most states, where there is a risk of a claim arising, paying super death benefits to beneficiaries directly may minimise the value of the pool of estate assets, and thereby mitigate this risk to a certain extent.
Bankruptcy is a complex area of law and therefore it is vital that clients seek advice from a qualified professional.
While a detailed discussion is outside the scope of this article, some relevant issues are considered below.
If an intended beneficiary is bankrupt or is in impending bankruptcy, careful consideration must be given to how super death benefits are directed to that beneficiary.
Generally speaking, lump sum super death benefits paid directly to a bankrupt beneficiary will be considered an interest from a superannuation fund, and accordingly will not be property that is divisible among creditors.
In contrast, super death benefits received by a bankrupt beneficiary via a distribution from an estate will generally not constitute an interest in a regulated superannuation fund.
Instead, having passed through the estate, the payment is considered to have lost the connection to being a superannuation interest.
Consequently, such a payment is not afforded the same protection.
If a beneficiary is neither bankrupt nor facing imminent bankruptcy, however, has the potential to become bankrupt in the future (e.g. due to being in a high-risk profession), it may be more appropriate to first direct super death benefits to the estate, and then to a testamentary trust.
Note: Should the beneficiary opt to receive the death benefits as an income stream, the degree of asset protection of superannuation would reduce as pension payments are not fully exempt under bankruptcy laws.
If structured appropriately, testamentary trusts can also provide a reasonable degree of asset protection in the event of a beneficiary’s marriage/de facto relationship breakdown.
Assets held within the trust, including any super death benefits, will generally not form part of the pool of assets of the beneficiary’s relationship, but is generally considered a financial resource.
The degree of asset protection afforded will depend on numerous factors, including who the controllers and beneficiaries of the trust are, and how long the trust has been in place prior to the relationship breakdown.
If, on the other hand, the beneficiary had inherited the super death benefits directly, those assets may have a higher chance of being taken into account when making orders regarding the division of the couple’s property.
A concern of many clients is that if their minor children were to receive their assets upon their death, the child(ren) may not make the best financial decisions in regards to their inheritance.
Similar concerns may arise when dealing with special needs beneficiaries.
A testamentary trust can provide a control mechanism to alleviate this concern, as it allows clients to elect a specific age for the child(ren) to access the capital and/or take control of the trust.
A nomination to the estate would need to be in place in respect of the super death benefits and the will updated to create a testamentary trust upon death to facilitate this.
Grandfathering of account based pensions
It may be advantageous from a social security perspective for an eligible beneficiary to receive a death benefit income stream as an automatic reversionary beneficiary.
Means testing for social security payments
For a beneficiary who is a recipient of a means tested social security entitlement (e.g. Age Pension), a lump sum inheritance received either directly from a super fund or via the estate will generally be exempt under the income test.
However, the continuing asset and income test treatment will be determined by how the beneficiary makes use of the proceeds.
For example, where beneficiary invests the funds in a share portfolio, the value will be assessed as an asset and deemed.
In comparison, the treatment may differ if the recipient is a beneficiary of a testamentary trust.
The assets and income at the trust level are ‘attributed’ to the surviving spouse of the deceased, where the spouse is a:
- trustee and/or appointor of the trust; or
- beneficiary of the trust and an associate (eg adult child) is a trustee and/or appointor.
Non-spouse beneficiaries are generally assessed under the standard attribution rules.
Broadly, if they are deemed to control the trust, the assets and income of the trust are ‘attributed’ to the beneficiary.
Beneficiaries who are not deemed controllers will simply have the actual distribution from the trust assessed as income for 12 months from the date of the resolution to distribute.
For eligible beneficiaries with a severe disability, a special disability trust set up through the will with estate assets may be social security-friendly.
Specifically, an assets test exemption of up to $657,250 (indexed) is available to the beneficiary in respect of trust assets, and income generated by the trust’s investments is also exempt from means testing.
Accordingly, correctly structuring a gift using a testamentary trust may represent an opportunity for beneficiaries to maximise their social security entitlement.
When it comes to the payment of super death benefits, there is no ‘one size fits all’ solution. Analysis of a number of factors is required on a case-by-case basis to determine the optimal course of action.
Mindy Ding is a technical consultant at AMP.