(03) 9020 2905PORTFOLIO POINT: Death taxes expanded! A new Tax Office position on super pensions has major repercussions for super and estate planning.
It was bound to happen.
I’d choose an important topic for a series of columns – super and estate planning – where the rules haven’t changed dramatically for a long time, and … bingo, the Tax Office goes and changes them. Dramatically.
To the point where it could cost tens, potentially hundreds, of thousands of dollars in the equivalent of a super death tax if proper planning doesn’t take place.
In two recent columns on superannuation and estate planning (Part I on July 6 and Part II on July 20), I stated that “reversionary pensions were a topic for another day”.
That topic for “another day” is now. Consider today Part III of the previously two-part super and estate planning series.
So, what’s happened? The ATO has hardened its previously flagged view that when a member dies, the pension immediate ceases. Their super fund immediately reverts back from pension to accumulation. (And that these are the rules that have applied since July 1, 2007, when tax-free pensions started, the ATO claims.)
The tax consequences are potentially enormous. If your super fund goes back to accumulation, it resumes paying tax. And not just on income. It could cause major capital gains tax issues.
For example, say a member had $500,000 in their super fund. They turn on the pension at age 60 and by the time they’re 75, their super fund assets have grown to $1,000,000. They’ve held on to all of the same assets – and why wouldn’t they, as they’ve done so well over that decade?
Then the member dies.
The ATO’s position is that at the point of death, the pension switches back to accumulation. If the trustee/member has held on to the shares throughout the pension period, CGT will be payable on the asset base of $500,000.
In this example then, a capital gain of $500,000 has been made and tax of $50,000 would be payable (assuming a 10% CGT rate).
And any income earned by the previously tax-free pension would also be taxable. Given that some estates can take many years to wind up, there could be a heck of a tax bill for the beneficiaries.
The ATO argues that it hasn’t “changed” the rules, that they’ve just interpreted the current law.
However, their draft tax ruling in regards to superannuation pensions and when they commence and cease challenges what industry professionals have long believed to be the case.
A significant section of the industry claims the ATO’s view is an incorrect interpretation of the law, and believe a challenge to any final ruling is inevitable. Andrew Cullinan, a director of the Small Independent Superannuation Funds Association industry group, says even if that’s what legislators meant when the laws were drafted prior to their introduction on July 1, 2007, that’s not what a strict reading of the act says.
SMSF professionals have long made the argument that because the pension itself was tax free, that the fund should then pass tax-free to beneficiaries.
If the ATO’s position sticks, super funds (SMSFs and retail funds) are going to have to make major changes to the way they structure their pensions.
How to make sure your pension stays tax free
If you want to pass your super pension to dependants tax-free, then reversionary pensions need to be automatic reversionary pensions (with no discretion for the trustee). Automatic reversionary pensions are going to need to become an almost compulsory part of SMSF/superannuation estate planning.
A reversionary pension passes the pension, as is, to the dependant. If the recipient is a financial dependant, then the pension remains in force and will continue to be tax free.
One of the implications of the ATO’s draft ruling, if adopted, is that the discretion of trustees to create a reversionary pension post-mortem will be removed.
If the reversionary pension wasn’t set up properly prior to death, then it will no longer be an option for trustees to belatedly change the pension to a reversionary pension.
In many cases, this is going to require an update of trust deeds (see below).
Many SMSF trust deeds won’t allow reversionary pensions and will need to be updated, if that tax element is an important part of your estate planning requirements.
Potentially, also, binding death benefit nominations that included a reversionary pension for dependants, could work as a stop-gap, according to Cullinan. They are not the best option, he says, because of their need to be updated every three years.
James Carson, principal adviser with Charlton Financial, says estate planning within super funds will fundamentally change, but is another big tick to SMSFs as a flexible structure for retirement income planning.
“This is significant, really significant, for estate planning, because this is going to be important to … find out how pensions are structured,” Carson says.
“A lot of those (industry, retail, corporate, government funds) won’t let you have reversionary (pensions) and a lot won’t let you have a reversionary (pension) with the terms and conditions that you set.
“You have a lot more flexibility with a SMSF with your reversionary pensions. You might have a pension that, on your death, reverts to the husband/wife and then on his/her death, reverts to the kids. Try getting that flexibility in a retail fund.
“But the important thing is that you have got to get your pension set up properly at the start. You have to have the documents supporting the pension up front. In your pension minutes, pension documents, it has to be really clear who it reverts to and the terms and conditions of the reversion.”
Refreshing your cost base
For those who are in a pension, strategies such as refreshing your cost base could also become extremely important in pension phase to lower potential capital gains tax liabilities.
That is, by selling and buying new shares in pension phase, you could lift the “cost base” of your portfolio from my example above, from $500,000 to $1,000,000, which would also minimise any tax to be paid on death.
But, again, you’ll have to be careful of “wash sale” rules. Wash sales are considered to be sells and buys where the only reason for the transactions is to avoid tax.
To avoid potential scrutiny for wash sales, you need to be careful of such things as not buying back the same number of the same shares on the same day.
Using quality trust deeds
The quality of your deed is going to be of fundamental importance. Older trust deeds might not allow for reversionary pensions, or reversionary pensions to a wife/husband that can then be made reversionary to dependent children up on the partner’s death.
The ATO is seeking comments on its ruling up to August 26.
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Nothing you read in today’s column is a substitute for proper estate planning advice, which should take in the services of solicitors, financial advisers and accountants and cover not just your super but your entire base of assets.
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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 advised to consult your financial adviser.
Bruce Brammall is director of Castellan Financial Consulting and author of Debt Man Walking.