Making death less taxing for your kids

SUMMARY: Do you want to make it tax-free for the next generation? A recontribution strategy requires some forward planning.

We all know and love super as this great income stream that comes to us tax-free eventually, usually after we turn 60 or 65.

Well, most of it comes tax-free to nearly all of us. There are a few exceptions and there are regular (largely political) threats to it staying that way.

For example, those who have enjoyed “untaxed” funds paid into their super will have to pay tax when they receive their funds. And the former government wanted to tax pension funds with incomes greater than $100,000.

Something that is less well understood is that superannuation is not necessarily passed on tax-free to the next generation.

You could often be leaving your children with considerable tax bills when you fall off your perch. Potentially up to 31.5% of your fund could be lost in a lump sum tax, as it passes through your estate.

Is it common? Yes. In fact, some of your super being lost to the tax man before being passed on is incredibly common, if not the norm. And it will happen to almost everyone who leaves super to a child over 18.

If the majority of Australians are those who die when the kids are over 18, then there are some potential big tax bills waiting for you and your untimely death to inflict on your children.

But there are several things you can do to minimise the tax debt you leave on your death. And they require careful planning.

What are the potential issues?

Superannuation will only pass on to the next person tax-free under certain circumstances.

Most broadly, it is designed to be left to financial dependants – your spouse and underage children – tax free. However, it goes a little wider than that.

The actual definition is a “death benefits dependant” and it is determined by the Tax Act, rather than superannuation legislation. A death benefits dependant includes:

• Your spouse (including defacto)
• A former spouse
• A child aged less than 18
• Those with which you have shared a interdependency relationship immediately prior to death
• Others who were financially dependant on you just before you died.

Adult children are the big one missing here. And it is here where there is most tax likely to be paid. You can leave super directly to your adult children (that is, not through your estate), but they will most likely have to pay tax on it.

Essentially, if you are leaving everything to a death benefits dependant, they will get it all tax free.

However, if it is being left to someone who is not considered to be a death benefits dependant, some tax is likely.

Table 1: Tax treatment for non-dependants

Important note: We are not dealing today with the tax treatment of death benefit income streams, which have a separate taxation treatment. Pensions can also only be paid to superannuation dependants (Superannuation Industry Supervision Act dependants), so not adult children, for example. I will deal with this topic on another day.

Imagine then that you’ve worked most of your life in the public service, under a untaxed defined benefit scheme. If received as a lump sum, your kids are going to lose up to 31.5% of the amount in tax. A $1 million super fund, in this example, could lose up to $315,000 to the ATO.

Obviously, you want as much as possible to be labelled as “tax free component” in your super fund. The main way of getting higher tax free portions of your super fund is through straight non-concessional contributions, which are after tax contributions.

How to lessen the tax damage?

One way of reducing the tax damage is via a recontribution strategy, which is not something that can be done after you die.

A recontribution strategy is where money is withdrawn from super and then recontributed.

Why would you do that? Because you change the tax elements that make up your super fund – the recontributed funds would return to super as non-concessional (tax-free) contributions.

How does this happen? Let’s take someone with a $600,000 in super. He is 57, divorced and looking to start a TTR pension. He does not wish to leave money to his previous partner and wishes instead to leave it to his adult children. He has previously made some non-concessional contributions to super and now find that half of his super fund is taxable. That is, if our super member were to die now and successfully leave this money to his adult children (by way of, say, a binding nomination), the member’s children would be paying tax on half of the benefits they receive.

How would a recontribution strategy change that? The tax-free threshold for FY14 is $180,000, so our member could withdraw enough to use up that sum. Any super taken has to be in proportion, so he can take a total of $360,000 from his super, being $180,000 from both the taxable and tax-free components.

This $360,000 amount would go back in to super as non-concessional contributions, so he would need to be aware of his non-concessional contribution limits and the pull-forward rule ($450,000 over a three year period). If his previous contributions were recent, he would need to take that into consideration before implementing this strategy.

Table 2: Changing taxable components

Prior to the recontribution, half of the member’s $600,000 super fund would have been taxed on leaving the money to his children. Now just $120,000, or 20%, would be taxable if leaving it to his adult children.

Before, the tax would have been 16.5% of $300,000 ($49,500), while now his death would cause a tax bill of 16.5% of $120,000 ($19,800).

(A second use for a recontribution strategy – reducing tax on income streams taken prior to turning 60 – was discussed in this column, 24/11/10.)

Recontribution strategies certainly aren’t dead. And they need to be implemented before you are.

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The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.

Bruce Brammall is director of Castellan Financial Consulting and the author of Debt Man Walking. E: bruce@castellanfinancial.com.au