Superannuation payments upon death

Technical Bulletin Superannuation payments upon death October 2009 Summary 1. Definition of a dependant 1.1 Dependant for superannuation purposes (SIS 1 ) This technical bulletin looks at death benefits paid from taxed superannuation funds and the current rules for paying such benefits which include: who can receive a lump sum death benefit under superannuation law; taxation of lump sum death benefits; limitations on who can be paid a death benefit as an income stream; and tax treatment of death benefits paid as a pension. Trustees can generally only pay death benefits to a dependant under superannuation law or the legal personal representative of the deceased member. The tax treatment of death benefits depends on whether they are made to a dependant under taxation law. The two definitions of dependant are described below. For members of superannuation funds, superannuation law defines a dependant to include: (but not former spouse), the deceased person s spouse the deceased person s child, any other person with whom the deceased had an interdependent relationship 2, any other person who was financially dependent 3 on the deceased at the time of death. Spouse is further defined to include another person (whether of the same or a different sex) in a registered relationship 4 and a de-facto spouse. A child includes: an adopted child, a stepchild, ex-nuptial child of the person, a child of the person s spouse and someone who is a child of the person within the meaning of the Family Law Act 1975 (for example, a child who is considered to be a child of a person under a state or territory court order giving effect to a surrogacy agreement). 1 Superannuation Industry (Supervision) Act 1993 2 Two persons have an interdependency relationship if: a. they have a close personal relationship; and b. they live together; and c. one or each of them provides the other with financial support; and d. one or each of them provides the other with domestic support and personal care. In addition, two persons also have an interdependency relationship if they have a close personal relationship, yet do not satisfy one or more of requirements (b), (c) or (d) above because either one or both of them suffer from a physical, intellectual or psychiatric disability. 3 It is generally accepted that this inclusive definition would also include a person who was financially dependent on the deceased at the time of death. For superannuation purposes, partial financial dependency can generally be sufficient to establish a relationship of dependence (Superannuation Circular No I.C.2, Paragraph 16). 4 Registered under a law of a State or Territory prescribed for the purposes of section 22B of the Acts Interpretation Act 1901 1

1.2 Death benefits dependant for tax purposes A death benefits dependant, of a person who has died, is: the deceased person s spouse 5 or former spouse; the deceased person s child 6 aged less than 18; any other person with whom the deceased person had an interdependency relationship just before he or she died; or any other person who was a financial dependant of the deceased person just before he or she died. While the SIS definition tells a trustee to whom a death benefit may be paid, the tax definition is used to ascertain whether any tax is applicable to the death benefit paid. The differences mean that a person who is considered a dependant under SIS may not be considered a dependant for tax purposes. For example, an adult child is treated as a dependant for SIS purposes but as a nondependant for tax purposes (unless financially dependent or had an interdependency relationship with the deceased). In this case, SIS enables the trustee to pay the benefit to the adult child but the benefit will be taxed as a non-dependant. For the payment of a death benefit, the following table provides a general summary of who is considered a dependant for: superannuation purposes (ie who can the benefit be paid to); taxation purposes (ie will they receive the benefit tax free); and anti-detriment purposes (ie who may receive an increased death benefit) See section 2.4 below. Summary table generally who is a dependant? Dependant for. Super Taxation Anti - detriment Child under 18 years of age Yes Yes Yes Child 18 years old or over and a financial dependant or in an interdependency relationship Child 18 and over and not in above categories Yes Yes Yes Yes No Yes Spouse Yes Yes Yes Former spouse (who is not a financial dependant) Former spouse (who is a financial dependant) Financial dependant (who is not a spouse, former spouse or child) Interdependent (who is not a spouse, former spouse or child) No N/A 7 N/A 7 Yes Yes Yes Yes Yes No Yes Yes No The estate Superannuation death benefit payments may be paid to a deceased estate. The tax treatment of benefits depends on who receives the payment from the estate. An anti-detriment payment may be payable to an estate to the extent that an eligible beneficiary (see table above) will benefit from the death benefit payment. 2. Death Benefit s paid as a Lump Sum 2.1 Paid to a dependant A death benefit paid to a tax dependant will be paid tax free. 5 The definition of spouse under the Tax Act replicates the definition of spouse under the SIS Act 6 The definition of child under the Tax Act replicates the definition of child under the SIS Act 7 A former spouse who does not meet another SIS Act definition of dependant cannot receive the payment. If they can be regarded as a dependant under the SIS Act they would be entitled under the Tax Act to receive the benefit tax free and may receive an anti-detriment payment if the Trustee chooses to claim the relevant tax deduction. It may be possible for a former spouse to receive a benefit via an estate. 2

Note 2.2 Paid to a nondependant Rex dies leaving a benefit of $1.5 million in his superannuation fund. The benefit comprises a tax-free component of $500,000. The trustee determines the entire benefit will be paid to Bree, his wife, as a lump sum. Bree will receive $1,500,000, as the entire death benefit is tax free because she is a dependant for tax purposes. Lump sum superannuation death benefits paid to non-dependants of Australian Defence Force and police personnel who have died in the line of duty will receive the same concessional tax treatment as if the benefit is paid to a dependant. A death benefit paid to a non-dependant for tax purposes will be taxed in the following manner: Component Tax-free component Taxable component Taxable component (untaxed element) Tax Treatment Tax free Taxed at 15% plus Medicare levy Taxed at 30% plus Medicare levy Susan dies leaving a benefit of $1.5 million in her superannuation fund. The benefit comprises a tax-free component of $500,000. The trustee determines the benefit will be paid to her daughter Julie, aged 28, as a lump sum. As Julie was not financially dependent on her mother, she is classified as a non-dependant for tax purposes. Julie s benefit will be paid as follows: Taxable component $1,000,000 Tax withheld at 16.5% - $165,000 (16.5% x 1,000,000) Total Death Benefit payable $1,335,000 2.2.1 Untaxed element An untaxed element will only arise where the lump sum death benefit contains an insurance payment, and is paid to a non-dependant for tax purposes. Such a benefit paid to a non-tax dependant, requires a calculation to determine the untaxed element of the taxable component of the death benefit superannuation lump sum. In order to calculate the untaxed element of the taxable component of the death benefit, the following calculations are required: Step 1. Reduce total benefit: Amount of days in eligible service period 8 superannuation X --------------------------------------- lump sum days in total service period 9 Step 2. Step 3. Reduce the amount calculated in Step 1, (but not below zero) by the tax free component (if any) of the superannuation lump sum. The result is the taxed element of the taxable component. The element untaxed in the fund is the taxable component minus the taxed element. Let s assume that Susan also had life insurance cover within the superannuation fund. The insurer pays a benefit of $500,000 which is included in the death benefit payment to be paid to Julie, which now totals $2,000,000. In order to calculate the untaxed element of the taxable component of the death benefit, the following calculations are required: 8 Days in eligible service period (ESP) are the number of whole days in the eligible service period to date of death. 9 Days in total service period (TSP) are the sum of the number of whole days in the ESP and the number of whole days in the period commencing on the date of the death of the member of the fund and ending on the last retirement date (i.e. the date by which the person s employment would have normally ended, however, in the absence of an ascertainable date this is usually the date of the person s 65th birthday). 3

Date of Birth : 1/3/1956 Account Balance: $2,000,000 Date of Death: 1/1/2010 Tax-free component: $500,000 Date at age 65: 1/3/2021 Taxable component: $1,500,000 Eligible service date: 1/5/1981 Days in ESP: 10,473 Days in TSP: 14,551 Step 1. $2,000,000 X [10,473 14,551] = $1,439,489 Step 2. Step 3. $ 1,439,489 - $500,000 = $939,489 (taxed element) $1,500,000 - $939,489 = $560,511 (untaxed element) Julie s benefit will be paid as follows: Taxable component $1,500,000 Tax withheld (taxed element) at 16.5% - $155,016 (16.5% x 939,489) Tax withheld (untaxed element) at 31.5% - $176,561 (31.5% x 560,511) Total Benefit payable to Danielle $1,668,423 2.3 Paid to the estate 2.4 Anti-detriment payment Death benefits paid as a lump sum to the deceased s estate are taxed within the estate depending on whether the beneficiaries of the estate are dependants or non-dependants for tax purposes. The trustee of the superannuation fund provides the components of the benefit to the legal personal representative (LPR) who is required to calculate and deduct tax (where applicable). Ian dies leaving a benefit of $1.8 million in his superannuation fund. The benefit comprises a tax-free component of $400,000. Ian nominates payment to his estate. The superannuation fund pays $1,800,000 direct to the estate, advising the tax components to the LPR. The LPR of the estate will then be required to calculate and deduct the applicable tax before paying the beneficiaries. Where a death benefit is paid as a lump sum, the trustee may claim a deduction for an increase to the death benefit which broadly reflects contributions tax paid during the time the benefit was accumulating. The deduction is only available to a trustee where an amount equivalent to the deduction has been paid as part of the death benefit lump sum to a spouse 10, former spouse 11 or child 12 of the deceased. Although an adult child of the deceased does not ordinarily meet the definition of a dependant for tax purposes, they may be eligible to receive an anti-detriment payment where the trustee has determined to make anti-detriment payments available. Trustees are not required to calculate and make an anti-detriment payment, and they may not be in a position to. The additional payment must be made before the deduction is claimed. This means that trustees must have access to a taxation reserve or alternative source of money, other than members accounts, in order to make the payment. Anti-detriment formula Where the trustee determines that it is able to make an anti-detriment payment, a calculation must be made to determine the value of this payment. The legislative formula to calculate the deduction is determined by: Tax saving amount / 15% 10 Spouse includes a de-facto or same sex spouse. 11 It is important to note that a former spouse is considered to be a dependant for tax purposes, but not a dependent under SIS. This means that unless the former spouse can prove they meet a non-spouse definition of dependant under SIS, such as a financial dependant, they would not be entitled to receive any of the death benefit or any anti-detriment payment. 12 Child includes a child of the person s spouse. 4

The Commissioner has approved two methods by which to calculate the tax saving amount. The first method is for the Trustee to calculate the actual tax saving amount. In order to do this correctly it requires the Trustee to track the effect of fund tax on individual accounts over the persons entire membership period. The Trustee may also take into account the earnings 13 that would have accrued if no tax had been imposed on contributions included in the funds assessable income throughout that period. This may prove very difficult for Trustees where adequate records are not maintained or a member has rolled monies in from other superannuation funds. Alternatively, the ATO have accepted the following formula provided in ATO ID 2007/219. This is the method that most public-offer superannuation funds use. ( 0.15 * P ) / ( R 0.15 * P) * C Where: P = The number of days in component R that occur after 30 June 1988. R = The total number of days in the service period that occur after 30 June 1983. C = The taxable component of the lump sum, after excluding (if any) the insured amount of the benefit. Let s revisit Susan who died on 1 January 2010 and leaves her entire superannuation benefit to her adult daughter Julie. Prior to death, her balance is comprised of $1.5 million in accumulation of which $500,000 is a tax free component. Susan was also insured for $500,000 in life cover. Taxable component (C) $1,000,000 Life cover (excluded from calculations) $500,000 ESP = 01/05/1981 P = 7,855 R = 9,682 Tax saving amount = (0.15 x 7,855) / (9,682 0.15 x 7,855) x 1,000,000 = $138,557 Where the Trustee pays an anti-detriment payment, this tax saving amount must be passed on as an additional death benefit. In this case Julie would receive: Taxable component $1,000,000 Life cover $500,000 Anti-detriment amount $138,557 Tax withheld $360,263 Gross Payment $1,778,294 2.5 Time limit to pay a death benefit from an income stream A superannuation benefit resulting from the commutation of an income stream after the death of the receiving member must be paid within the later of the following limits in order to be treated as a superannuation death benefit: 6 months of the date of death, or 3 months from grant of probate or letters of administration in relation to the deceased s estate, or If the payment is delayed because of legal action about entitlement of the benefit 6 months after the legal action ceases; or If the payment is delayed because of reasonable delays in the process of identifying and making initial contact with potential recipients of the benefit 6 months after that process is completed. 13 ATO ID 2008/111 5

If the benefit is paid outside these time limits, it will be regarded as a superannuation member benefit, not a death benefit, and taxed as such. 3. Death Benefits paid as a Pension 3.1 Who can be paid a pension? There are restrictions on who can receive a member s superannuation death benefits in the form of a pension. Generally only SIS dependants can receive a death benefit income stream with certain restrictions applying to children. 3.2 Compulsory commutation for child of the deceased paid a pension A death benefit may be paid as a pension to a child of the deceased member if the child: is under the age of 18; or is under the age of 25 and financially dependant on the member; or has a disability. The pension must be commuted at or before the child s 25th birthday, unless the child has a disability. The lump sum paid on commutation will be tax-free. It is our view that partial commutations are not possible. 3.3 Tax payable when the deceased and/or beneficiary are aged 60 or over If either the deceased was aged 60 or over at the time of their death or the beneficiary is aged 60 or over, all payments made from the pension to the beneficiary will be tax-free. Lynette was aged 62 at the time of her death and leaves a death benefit of $900,000, with a tax-free proportion of 25% (i.e. $225,000 tax-free component). Her husband Tom, aged 57, is the beneficiary and requests the death benefit to be paid as a pension. Tom has requested the minimum payment ($36,000 or 4% x $900,000) and he will receive this tax-free as Lynette was over 60 at the time of her death. This treatment also applies to existing reversionary pensions, even if the reversionary started receiving the pension payment before 1 July 2007. If neither the deceased or the beneficiary are aged 60 or over at the time of death, the pension will be treated for tax purposes as a pension payable to a person aged between their preservation age and age 60. 3.4 Tax payable when the deceased and beneficiary are both aged under 60 The taxable component of the payments will be included in the beneficiary s assessable income and will be eligible for the 15% tax offset. They will be taxed in the following way: Component Tax-free component Taxable component Tax Treatment Tax-free included in assessable income eligible for 15% tax offset 14 Refer to the SIS Act definition of a Spouse 15 Refer to the SIS Act definition of a Child 16 The definition of disability (subsection 8(1) of the Disability Services Act 1986) is a person with a disability that: is attributable to either, or a combination of, an intellectual, psychiatric, sensory or physical impairment; is permanent or likely to be permanent; and results in: - a substantially reduced capacity of the person for communication, learning or mobility; and the need for ongoing services. 6

Victor was aged 58 at the time of his death and leaves a death benefit of $900,000 with a tax-free proportion of 25%. His wife Gabrielle aged 55, requests the death benefit to be paid as a pension, which will commence 1 July 2008. Gabrielle requests a payment of $60,000 per year. Assuming Gabrielle has no other income; her payments will be calculated as: Gross Payment $60,000 Tax-free component $15,000 (25% x 60,000) Taxable component $45,000 Withholding tax at 15% - $4,350 (15% x {35,000 6,000}) Withholding tax at 30% - $3,000 (30% x {45,000 35,000}) Tax offset (15%) $6,750 (15% x 45,000) Medicare levy - $675 (1.5% x 45,000) Total tax and Medicare payable - $1,275 Net payment $58,725 Once Gabrielle turns 60 the pension payments will be tax free. Tips Where tax dependents are available, consider increasing death cover inside superannuation, as there are no taxation issues to consider when paying large death benefits. If a client has no dependants for tax purposes, consider holding life insurance cover outside superannuation, to avoid additional tax on an untaxed element of the taxable component being calculated. Find out whether the fund you are using is able to make anti-detriment payments. Review death benefit reversionaries existing on 1 July 2007 who are aged under 60, who have a superannuation income stream from a death benefit, where the deceased was aged 60 or over at time of death, to ensure they are receiving their pension payments tax-free. Legislative Income Tax Assessment Act references Section 302-195 Superannuation Industry (Supervision) Act 1993 Section 10 Family Law Act 1975 60HA FOR GENERAL INFORMATION ONLY This information has been prepared by BT Funds Management Ltd ABN 63 002916 458. It is provided solely for the general information of external financial advisers and must not be relied on as a substitute for legal, tax or other professional advice. Further, it must not be copied, used, reproduced or otherwise distributed or circulated to any retail client or other party. The information is given in good faith and has been derived from sources believed to be accurate at its issue date. However, it should not be considered a comprehensive statement on any matter nor relied upon as such. BT Funds Management Ltd (including its related entities, employees and directors) does not give any warranty of reliability or accuracy or accept any responsibility arising in any way including by reason of negligence for errors or omissions in the information. 7