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Death and disability tax efficiency

Tim Miller looks at the merits of claiming future service period tax deductions when an SMSF member suffers ill health or passes away.

Despite the onslaught of superannuation reform measures, SMSFs remain one of the most powerful retirement income and estate planning vehicles.

With the introduction of the transfer balance cap and the removal of the ability to pay an anti-detriment payment from 1 July 2017 (payments are still possible if the death occurred prior to 1 July 2017 and the anti-detriment payment is made prior to 1 July 2019), should an SMSF contemplate claiming a future service period deduction when a member dies, is terminally ill or becomes disabled prior to age 65?

Paying a death benefit is inevitable

It was Benjamin Franklin in 1789 who stated “in this world nothing can be said to be certain except death and taxes”, and it’s true. But it is also true we can reduce our taxation liability even if it’s not directly as individuals but rather inside an SMSF.

Ideally it would be preferable when a member dies to leave tax dependants the benefit of what we have accumulated, knowing they won’t have to pay any upfront taxes, or as little as possible. While it is important to consider who a benefit is paid to, as this will determine the tax to be withheld on the payment, we should also consider the future tax consequences.

Due to the current tax-friendly nature of superannuation, yes even in a post-transfer balance cap environment it is still very friendly, opportunities continue to exist for monies to be recontributed or retained in super. Opportunities also present themselves to assist us in minimising the future tax liability of a fund for existing or new fund members.

Transfer balance cap and ECPI

Prior to 1 July 2017, the most common death benefit strategy for a two-member fund was for the surviving spouse to receive a pension from the deceased and to continue to receive a pension for themselves if they were eligible. This maximised the tax effectiveness of the fund as the income on the assets was subject to the exempt current pension income (ECPI) deduction.

The introduction of the transfer balance cap requires us to reconsider this strategy as an individual can have no more than the transfer balance cap of $1.6 million to commence a pension. Therefore, in the instance where a member receives a death benefit pension from their spouse, their own pension may, in some instances, be commuted back to accumulation. When this occurs the fund will only be entitled to ECPI on the pension amount.

Now, more than ever, insurance has a part to play in increasing a member’s benefit and availing a fund to certain tax deductions.

Disability too

The opportunities identified below do not exist solely for SMSFs paying death benefits, but also for an SMSF paying a disability benefit. Again, this is likely to provide a tax benefit as it is now questionable whether a member will commence a disability income stream over taking a lump sum because they may not wish to trigger their personal transfer balance cap at an earlier age.

Deductions available

Subdivision 295-G of the Income Tax Assessment Act 1997 (ITAA) outlines the various deductions available relating to death and disability benefits. The focus of this article is section 295-470 “Complying funds – deduction for future liability to pay benefits”.

Future liability to pay benefits

Section 295-470 allows a fund to claim a deduction on payment of:

  1. superannuation death benefit, or
  2. a terminal illness benefit, or
  3. a disability superannuation benefit, or
  4. a temporary incapacity income stream.

The payment of a, b or c must be as a consequence of termination of a member’s employment and is eligible whether a benefit is paid as a lump sum or taken as a pension.

The formula for calculating the deductions is as follows:

Benefit amount x future service days/total service days.

Benefit amount is the lump sum or the purchase price of the pension or the total of the amounts paid during the income year in the instance of a temporary incapacity income stream.

Future service days is the number of days from the date of termination to the member’s last retirement day (age 65).

Total service days is the sum of future service days plus the member’s eligible service period to the day of termination.

Losses created by this deduction can be carried forward. This is the significance of the deduction for SMSFs as the deduction may not have a great impact in the year that it is claimed, but may provide an ongoing benefit for the accumulation interests of the fund.

Election to claim future liability deduction

Section 295-465 of the ITAA 1997 allows a fund to claim a deduction for death and disability insurance premiums where the policy is held within the superannuation fund. To be entitled to claim a deduction under the section, the fund must make an election under section 295-465(4) not to deduct amounts based on the premiums paid, but rather to claim on the future liability to pay benefits.

The election applies to all future years unless otherwise determined by the taxation commissioner. Therefore, if a fund elects in the year of paying a benefit to claim for future liability and not for premiums paid, it cannot in future years claim insurance premiums for other members of the SMSF. The fund can claim the premium-based deduction up to the year the benefit is paid and make the election then.

This requirement makes the future liability deduction more attractive to an SMSF as the deduction attributable to individual member premiums will in most instances be less significant. Retail and industry-based funds are less likely to claim this deduction due to the resulting loss of ability to claim annual premium deductions for all other members.

Of course with a deduction that provides the tax savings that this can, there are often drawbacks that need to be considered.

Untaxed element of a death benefit to a non-dependant

A superannuation death benefit paid to a non-dependant is taxable at 15 per cent plus the Medicare levy to the extent of the taxable component at the time of payment. If a deduction is claimed by a fund under either section 295-465 or 295-470 of the ITAA 1997, an untaxed element must be calculated as per the formula below. The untaxed element will be taxed at 30 per cent plus the Medicare levy.

Amount of superannuation lump sum x service days/service days + days to retirement.

The taxed element in the fund is the amount derived from the above calculation less any tax-free component of the superannuation lump sum; the amount cannot be less than zero. The balance is the element untaxed.

"Now, more than ever, insurance has a part to play in increasing a member’s benefit and availing a fund to certain tax deductions."

Tim Miller

Case study: future liability to pay benefits deduction

These calculations highlight the potential of the deduction and years have been used in the calculation. It is important when undertaking these calculations to use actual days.

Assumption 1 – dependent beneficiary

Bob is aged 45 and has 18 years service period. He dies on his 45th birthday, leaving a wife and a 20-year-old non-dependent daughter. He has a superannuation fund balance of $500,000 comprising a $300,000 taxable and $200,000 tax-free component. He also holds an insurance policy valued at $1 million.

Bob’s wife, Anna, is self-employed and makes deductible contributions to their SMSF. She has a balance of $300,000.

The fund has previously claimed a deduction for the insurance premiums paid so elects not to do so, but rather to claim a deduction for the future liability to pay benefits.

Deduction is calculated as:

$1,500,000 x 20 years/38 years.

So the section 295-470 deduction would be $789,474.

The SMSF had taxable income of $50,000 consisting of contributions, realised capital gains and other income.

In the first year the fund creates a carried-forward loss of $739,474 that can be offset against future contributions, gains and income.

In this example the payment of $1.5 million to Anna is tax-free as she is a dependant. Ultimately she can take it as a lump sum or a death benefit income stream. If she elects to take it as an income stream, the fund would be entitled to an ECPI deduction on the income generated on the $1.5 million, which would lessen the appeal of the deduction, which is used prior to applying the ECPI percentage.

Assumption 2 – non-dependent beneficiary

Let’s assume Bob and his wife have separated and so he wants to leave his superannuation proceeds to his daughter who is over 18 and not financially dependent. The daughter is also a member and trustee of dad’s fund. In the year of the father’s death, the SMSF makes the election to claim the section 295-470 deduction. The same amount is calculated as above, $789,473.

In addition to this, the death benefit payment to the non-dependent daughter requires the calculation of the taxed and untaxed element:

Element taxed in the fund = $1,500,000 x 18 years/38 years
Element taxed = $710,526 – $200,000 (tax-free)
Element taxed = $510,526 @ 17% = $86,790
Element untaxed = $1,500,000 – 710,526
Element untaxed = $789,474 @ 32% = $252,632
Total tax on death benefit = $339,422

Bob’s daughter will receive an after-tax death benefit of $1,160,578, but will have the deduction of $789,474 to offset against the future income of the fund.

The immediate reaction is that paying the additional tax is a price too high to pay. However, it must be remembered that because the fund has insurance and has been claiming a deduction on the premiums, the calculation was going to be required regardless. Therefore, if there is going to be such a tax hit to a non-dependant, then the future tax saving will lessen the overall impact.

There is no doubt the deduction is more attractive for a death benefit payment to a dependant, but there can also be traps.

One of the unintended consequences of the super reform is related to rolling over death benefit pensions. In assumption 1, if Bob’s wife took the $1.5 million as a pension and elected to roll the pension to another fund to maximise the deduction in the SMSF, this would trigger the calculation of the untaxed element. The industry awaits further information on this.

Conclusion

The introduction of the transfer balance cap means the death or disablement of a member will not automatically result in a fund paying a pension, but may lead to more lump sums being paid, or more money being retained in accumulation, where possible.

Funds paying death or disability benefits to members/beneficiaries while continuing to generate a taxable income should consider the arguments for and against claiming a future liability to pay benefits deduction subject to meeting the applicable conditions. With the capacity to roll over death benefit pensions, assuming the untaxed element issue is addressed, there are now more opportunities than existed prior to 1 July 2017.

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