You may have heard the saying that the only certainties in life are death and taxes.
Death and probate taxes were abolished in Australia by the early 1980s, however there is a potential inheritance tax-by-disguise hiding in your superannuation or pension fund you may not even know about.
The good news is that it’s avoidable.
Keeping money in super or a pension has the significant benefit of being concessionally taxed at 15 per cent on earnings and 10 per cent on capital gains in accumulation mode. The story gets even better in pension phase where there is no tax at all on balances up to $1.9 million.
However, it’s important investors strike the right balance between paying less or no tax now while they are enjoying the funds, and the risk of those funds being taxed on their death.
Funds paid to tax dependents — for example, between a husband or wife — are not usually subject to this tax. However, if funds are paid out to beneficiaries that are not tax dependents — for example to adult, independent children — a lump sum death benefit could be taxed at 15 or 30 per cent, plus the 2 per cent Medicare levy.
So, how is it best to manage this quasi death tax on super?
Moving funds out of super?
It is important to understand how much tax your beneficiaries are potentially exposed to. Only the taxable component of your balance is subject to this tax, so it’s important to know what proportion of your funds are taxable versus tax-free.
Once you know what tax your non-dependent beneficiaries may be facing, it’s important to get an understanding of what tax you are saving by keeping funds in a concessional or nil-tax environment.
For young retirees in good health, expecting to enjoy a long tax-free retirement income stream, the tax benefits they would receive over a 20 or 30-year period could outweigh any potential tax paid by beneficiaries. But older investors, or those in poor health, may calculate that the tax savings over the short term are not worth the risk of their beneficiaries paying tax.
If you determine that the risk of tax to beneficiaries outweighs the shorter term tax benefits, you could withdraw funds from the super environment and invest them in your personal name or other structure.
This is a delicate area and requires appropriate guidance and advice
Recontribution strategy
Because this tax is only paid on the taxable component of your funds, the aim of a super recontribution strategy is to reshuffle the different components of a fund in favour of the tax-free component.
To achieve this, assuming you have met a condition of release — retired from age 60, terminated a contract of employment after age 60, or have reached age 65 — you can withdraw money from your super fund that holds substantial amounts of taxable component, and recontribute these funds as non-concessional contributions.
Various restrictions — such as contribution caps, total super balances and the requirement to meet the “work test” if you are over the age of 74 (proving you had worked at least 40 hours in any consecutive 30-day period in a financial year) — can make this strategy sometimes difficult to execute.
If you can get the right assistance with juggling the various caps and restrictions, it could be possible to eliminate some, or even all, of the potential tax liability.
In some cases the ability to recontribute to your spouse’s super fund can — in addition to reducing your tax liability — have the added benefit of potentially boosting eligibility to Centrelink benefits.
Binding death nomination to your estate
Funds paid directly from your super or pension fund to a non-dependent beneficiary will attract an additional 2 per cent Medicare levy on top of the 15 or 30 per cent tax liability that could exist.
By directing benefits via your will, and having your estate distribute funds to your beneficiaries, this 2 per cent Medicare levy is avoided, even if the recipient of your funds is a non-dependent.
This involves nominating your estate, or legal personal representative, on your fund nomination forms.
Bear in mind this may have some potential draw backs, as there are situations where it is advantageous to have benefits bypass your estate and be paid directly to specific beneficiaries.
Appoint a power of attorney
While a will is an important document, it is also very important to appoint an enduring power of attorney to assist with financial matters when you can’t.
They may be able to make decisions on your behalf if you are incapacitated and take appropriate steps to prepare your funds for the best possible outcome for your beneficiaries.
If you have an adviser, ensure that your power of attorney knows who they are and they have open channels of communication for situations where they may need to work together when you can’t.
Everyone’s circumstances are different, and there are many considerations that can impact on the effectiveness and ability to execute the options listed above. It is therefore important to seek professional advice tailored to your individual situation.
Raymond Pecotic is the managing director of Empire Financial Group