Q: What is the tax impact of a life insurance benefit paid out upon the death of an SMSF trustee?
A: It is common practice for life insurance to be held within a superannuation environment due to the ability to claim a tax deduction on the premiums under sections 295-465 and 295-470 of the Income Tax Assessment Act 1997. However, before making this decision, other issues need to be considered to make sure it is a viable option. One of the main issues to consider is the taxation implications that may apply in respect of the eventual death benefit payment.
On the death of a member, the resulting lump sum death benefit that includes insurance proceeds may consist of a tax-free component and a taxable component. The taxable component is then broken up between a taxed and untaxed element. If the death benefit is paid to a tax dependant, then all components are non-assessable and exempt income. However, if paid to a non-tax dependant, the untaxed element of the lump sum death benefit is assessable income and taxed at a rate no higher than 31.5 per cent (inclusive of Medicare levy). It is also important to know that non-tax dependants can only receive a death benefit as a lump sum and not as an income stream.
Section 307-290 of the Income Tax Assessment Act 1997 states that when the trustee of a superannuation fund pays a lump sum benefit on the death of a member, and the trustee has claimed deductions for the life insurance premiums under section 295-465 or 295-470, the untaxed element of the fund needs to be calculated as follows:
Calculate the taxable component (taxed element). This is calculated based on the statutory formula contained under section 307-290 of the act. See the statutory formula in the table below, where:
- service days is defined as the number of days in the service period for the lump sum,
- service period is defined by reference to section 307-400,
- days to retirement is defined as the number of days from the death of the deceased member to the deceased’s last retirement day, and
- last retirement day is defined in section 995-1 as the day a taxpayer turns 65, or such other age as determined by their particular employment.
Reduce the amount calculated under the formula by the tax-free component. Do not reduce to below zero.
Calculate the taxable component (untaxed element). Gross death benefit payment (including insurance proceeds) – tax-free component – taxed element.
Individuals with a higher level of existing service days will have a lower untaxed component.
Let’s consider an example:
Sally dies on 1 July 2013 at the age of 45. At the time of her death, she had a superannuation interest of $500,000 ($300,000 tax-free) as well as having a $1 million life insurance policy through her SMSF. All of her superannuation interests, including the insurance proceeds, are to be paid out to her adult child, who is a non-tax dependant. Her eligible service date is 1 July 1991. The taxation impact that will apply to the lump sum death benefit payment is as follows:
- Taxed element: $1.5 million x 22 / 22+20 = $785,714
- $785,714 – $300,000 (tax-free) = $485,714
- Untaxed element: $1.5 million – $300,000 – $485,714 = $714,286
As the death benefit beneficiary is a non-tax dependant, the untaxed element is taxed at 31.5 per cent, that is, tax payable of $225,000.
Therefore, given the significance of the tax implications on the untaxed element, careful consideration needs to be given to many issues, that is, whether to gross up the amount of insurance cover to ensure adequate funding as well as considering rolling over old superannuation accounts so as to increase the eligible service period as well as careful analysis of the estate planning objectives of the member.
