If a client plans to leave their superannuation to a non-dependant (such as an adult child), a part of the death benefit could be eaten up by tax. This is because, unlike dependent beneficiaries (such as a spouse or young child), non-dependants have to pay tax of 16.5 per cent (including a Medicare levy of 1.5 per cent) on the taxed element of the taxable component.
One way to reduce or eliminate this tax burden is to cash-out some (or all) of the taxable component and re-contribute the amount as a personal after-tax contribution (which will form part of the tax-free component).
How does a re-contribution strategy work?
To use a re-contribution strategy, your client must meet a condition of release and be eligible to contribute to super.
If aged 60 or over, they can make unlimited tax-free withdrawals from the taxable component. However, if aged between 55 and 59, the maximum taxable amount they can receive tax-free is $140,000 (in 2007-08).
Regardless of their age, if your client’s benefit contains a taxable and tax-free component they will need to withdraw a proportional amount of both components, with the proportion struck at the time of withdrawal.
Furthermore, there is a cap on personal after-tax contributions (and other non-concessional amounts) that can be paid into super. This cap is $150,000 per annum (or $450,000 in one year if your client is under age 65 in that year and doesn’t make further contributions in the following two years).
Note: If your client is aged between 60 and 65, they could potentially take advantage of two consecutive caps of $450,000 and re-contribute a total of $900,000 over a four-year period (or $1.8 million if they have a spouse).
What about anti-detriment payments?
Before recommending a re-contribution strategy, you should consider whether your client’s beneficiaries would otherwise be eligible to receive an anti-detriment payment (which is broadly designed to refund the tax paid on contributions).
This is important because a spouse or child of any age (including a non-dependent adult child) is generally eligible for an anti-detriment payment when a death benefit is paid as a lump sum.
But because the anti-detriment payment is only paid on the taxable component, using a re-contribution strategy to convert the taxable component into the tax-free component could reduce (or eliminate) the anti-detriment entitlement.
Note: Some public offer funds and most industry funds don’t make anti-detriment payments. Also, self-managed super funds generally can’t pay anti-detriment amounts, unless they have fund reserves.
When you take into account the anti-detriment payment, Richard’s adult children (see case studies) would only have been 1.7 per cent better off if he used the re-contribution strategy.
The value added by re-contributing would, however, be higher if Richard had a service period that commenced before June 30, 1988, as the anti-detriment amount would be proportionally lower.
What if your client has a spouse or young children?
A re-contribution strategy should not be used if the fund makes anti-detriment payments and the death benefit will be paid to a spouse or young child. This is because these beneficiaries can receive unlimited tax-free lump sums — regardless of the components of the death benefit.
Also, by converting taxable benefits into tax-free benefits, they will forgo an anti-detriment payment.
Furthermore, even if his spouse pre-deceased him and the benefit went to his adult children (see case study 2), they would have only been slightly worse off if he had not re-contributed super benefits. This assumes they would have been entitled to the maximum anti-detriment uplift of 17.65 per cent.
Which approach is best?
When deciding whether to re-contribute for estate planning purposes, you need to consider who will receive the death benefit, whether the fund makes anti-detriment payments and the magnitude of the anti-detriment uplift.
Generally speaking, a re-contribution strategy:
n will be worthwhile if your client is sure their death benefit will go to their adult children;
n may not be worthwhile if your client has a spouse and adult children; and
n should not be considered if your client has a spouse or young children only.
Note: There is no need to use a re-contribution strategy if your client’s beneficiaries are financial dependants or interdependants. This is because these beneficiaries are not eligible to receive an anti-detriment payment and will be able to receive unlimited tax-free lump sums regardless of the components.
Other issues
Divide and conquer
Assuming a re-contribution strategy is suitable, if your client is unable to convert the entire taxable component into the tax-free component, they may want to contribute the withdrawn amount into a separate super account.
This will enable your client to commence two pensions — one comprising the residual taxable component and the other consisting primarily of the tax-free component (as earnings in the accumulation phase will be added to the taxable component).
Your client can then elect to draw primarily from the taxable pension and only take the minimum income required by law from the tax-free pension. This enables them to run down (even exhaust) the taxable pension and preserve the tax-free pension for their non-dependent beneficiaries.
Note: SMSF clients will need to establish a separate fund, as SMSFs are caught by the aggregation rules.
Pay an early inheritance
Rather than re-contributing super benefits, your client may want to withdraw tax-free super benefits at age 60 or over and pay them to non-dependent beneficiaries as an ‘early inheritance’.
The downside to this approach is that no one knows how long they will live and gifting the money too early could leave your client without sufficient funds to meet their ongoing living expenses.
Andrew Lawless is technical services manager at MLC.
