Should you fully withdraw super prior to death to minimise tax payable by your beneficiaries?

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How super benefits are taxed
Using the recontribution strategy to reduce tax on your super benefits

Did you know that when you pass away and leave your super to your non-dependent children as a lump sum, they may be liable to pay tax on that super death benefit?

To save or minimise this tax liability, some people who have been diagnosed with a terminal illness decide to withdraw their super in full, just prior to their death and have it deposited into their personal bank account.

At first glance, this may come across as a tax minimisation arrangement. Given the uncertainty around the timing of death, even with a terminal diagnosis, it can be difficult to plan for. But given many Australians die with a substantial amount left in their super account, it’s a strategy worth exploring if you find yourself in these difficult circumstances.

If your estate, non-dependent children, or any other non-dependent beneficiaries ultimately inherit your super death benefit, then there are ways to minimise their tax liability and keep the Australian Taxation Office (ATO) onside.

First, I’ll look at how this strategy works in theory and explain the ATO’s view before moving on to practical applications for super funds.

How super benefits are taxed

Before you embark on any estate planning, it’s important to understand the different tax components of your super accumulation and/or pension account, namely tax-free, taxable taxed and untaxed components.

Read more about the taxation of super withdrawals.

It is the taxable taxed and untaxed components that get taxed to your estate or the beneficiaries of your super fund after your death. Generally, adult non-dependent children pay 15% plus Medicare Levy (currently 2%) on the taxable component and about 30% plus Medicare Levy (or up to 32%) on the untaxed component. If the estate is the beneficiary, then it is 15% (no Medicare levy payable).

To give a quick example, say you passed away at 90 with a balance of $500,000 in your account-based pension that had a taxable component of $200,000. If your non-dependent child was to receive the death benefit, they would have a tax liability of $34,000 (15% tax plus 2% Medicare levy) making their net death benefit lump sum $466,000.

Using the recontribution strategy to reduce tax on your super benefits

If you are eligible, then financial advisers generally recommend the recontribution strategy to help reduce your taxable components to reduce this potential issue for your estate or non-dependent beneficiaries in the future.

Learn more about how a recontribution strategy can help with estate planning.

As the recontribution strategy cannot work under every situation (for example, if you are over 75), there is a high possibility you may still have a taxable component in your super in later life. In such cases, financial advisers usually advise clients who are seriously ill or on their death bed to withdraw all their super, if possible, and let it sit in their personal bank account. This is because that cash no longer remains in the super system and instead forms part of the estate. Cash is not taxable to your estate or your beneficiaries upon your death.

However, this strategy is not always straightforward and the ATO may have different views on it.

The main factor that determines whether withdrawing super on your death bed will be taxed or not is whether that money is considered a member benefit or a death benefit.

Need to know: The Income Tax Assessment Act 1997 states that a member benefit is “a payment made to a person because they were a superannuation fund member”. In contrast, a death benefit is “a payment made to a person after another person’s death because the deceased was a superannuation fund member”.

As you can see in the case studies below, issues can arise when arrangements are made to withdraw super prior to death but the money doesn’t hit the member’s personal bank account until after they die.

Note that the case studies are for general information only. The ATO states that for advice on specific circumstances, the executor or legal representative of a member’s estate can apply for a private ruling.

Case study 1 – If you have an SMSF

Adam and his adult son Dave are the members and trustees of their SMSF. Adam’s super is in an account-based pension and he has nominated Dave as the sole beneficiary of his super death benefit. Dave is a non-dependent adult child so when Adam dies, his death benefit will need to come out of the SMSF and paid to Dave. When this happens, Dave will be liable to pay 15% tax plus 2% Medicare levy on the taxable component of Adam’s death benefit. Adam is terminally ill and is on his death bed.

Adam makes a written request to the SMSF trustees (he and Dave) for a full withdrawal of his member balance from the SMSF, which is granted. Before the benefit payment is paid, Adam passes away. A few days later, the benefit hits Adam’s personal cash account.

As the remaining trustee, Dave now needs to determine whether the benefit payment was a member benefit or a death benefit.

In the ATO’s view, if a member requested an amount to be paid from their fund before they died, but died before they received it and the super fund trustees were aware of the death, then it is most likely considered to be a death benefit. In very limited circumstances it may be a member benefit. This is because in an SMSF, the members and trustees are generally spouses or family members who would be aware of a particular member’s death.

If Adam’s benefit was paid and credited to his personal bank account before he died, then no tax would have been payable on the cash sum.

Super tip: The important issue for SMSFs is the evidence that can be produced to prove intention. That is, if the SMSF trustees had received Adam’s withdrawal request and made the decision to make the member benefit payment prior to his passing, AND they can prove this with written documentation, then it could be argued that the payment was actually a member benefit payment and not a death benefit payment.

Case study 2 – If you have an APRA fund (e.g. industry super fund or retail super fund)

Adam is a member of an Australian Prudential Regulation Authority (APRA) regulated super fund where he has an account-based pension. Adam has nominated his estate as the beneficiary of his super death benefits. Adam becomes terminally ill and makes a request to his fund for release of his super benefits.

Before the benefit payment is made by the super fund, Adam passes away. The super fund’s trustee is only informed of Adam’s death after the benefit is paid in to Adam’s personal cash account.

Given the trustee of the super fund had no knowledge of Adam’s death at the time of making the benefit payment, the payment is most likely to be considered a member benefit. This means that Adam’s estate will not have to pay 15% tax on the taxable component because the benefit is not a death benefit.

While there is no one size fits all approach in these situations, the super fund trustee’s knowledge of the member’s death plays a crucial role.

Check out the ATO’s view on death benefits vs member benefits and examples of benefits paid from an SMSF or an APRA fund.