When a superannuation account enters pension phase, the earnings on assets financing the super pension are exempt from tax, subject to meeting minimum pension payment rules. What this means is that capital gains, dividend income, interest income and any other type of income that the super pension account receives is exempt from the tax system.
Note: If you choose to continue an accumulation account while also taking a pension from a pension account, then tax is still payable on fund earnings in the accumulation account. For example, fund earnings are subject to 15% earnings tax, although capital gains on assets that have been held for more than 12 months receive a 33.3% discount, which translates into a tax rate of 10% on those capital gains. You can also continue making contributions to the accumulation account, and if you’re aged 65 or over, you must meet a work test before making super contributions.
What about when a pension member dies?
SMSF pension earnings remain exempt from tax until a superannuation death benefit is paid to a dependant, or paid to the deceased member’s estate.
The tax exemption on pension earnings remains in place regardless of whether the death benefit is paid as a lump sum, or as a pension, provided the benefit is paid as soon as practicable. According to recent guidance from the ATO, ‘soon as practicable’ normally means the timeframe would not exceed 6 months from the date of death. If a longer period than 6 months is required, the ATO’s view is that the trustees of the super fund should be able to demonstrate why it was not practicable to pay the death benefit within 6 months.
Background: Regulations took effect from 1 July 2012 (although registered in June 2013) confirming that super pension earnings remain tax exempt upon the death of a fund member receiving a super pension, even when there is no reversionary pension (that is, the pension of the deceased fund member does not automatically revert to another person). The major condition of this continuing tax exemption, however, is that the death benefits must be paid out as soon as is practicable (refer earlier for an explanation of this 6-month timeframe).
The death benefits can be paid out as a lump sum or as a super pension and in the time between the fund member’s death and payment of the death benefits, the earnings on those pension assets remain tax exempt, subject to some exceptions involving life insurance payouts and anti-detriment payments.
Congratulations to the former ALP federal government for applying common sense when dealing with death benefits paid to beneficiaries from a superannuation pension account.
I also commend the ATO for taking this pragmatic position on death benefits paid before July 2012 and after June 2007, because I have always believed the correct position should be that a superannuation pension continues until death benefits linked to that super pension are paid (more on the history of the ATO position, and my views, later in the article).
Note: The regulations took effect from the 2102/2013 year, and the ATO’s compliance position (for the period 1 July 2007 until 30 June 2012) on the tax exemption of pension assets beyond death is now confirmed. The proposed tax on pension earnings exceeding $100,000 was rejected by the Liberal government, while ALP went to the 2016 election with a super policy to tax pension earnings exceeding $75,000 a year. Instead the Liberal government has placed a cap on the amount of super that a person can move into pension phase. See next paragraph.
Update: Taking effect from 1 July 2017 (subject to legislation), the government is imposing a cap on the amount of super that can be transferred into pension phase (see SuperGuide articles Burden for retirees: Monitoring $1.6 million transfer balance cap and Superannuation death benefits and the $1.6 million transfer balance cap ). The government is also abolishing the anti-detriment payment rules (see SuperGuide article Anti-detriment payments banned from July 2017).
Why is SuperGuide writing about whether earnings tax is payable after a member dies?
The government’s 2013 amendments to the regulations, only state that the tax exemption on pension earnings upon death, where there is no reversionary beneficiary, apply from 1 July 2012 and into the future. The government did not deal with the ATO’s earlier statements that the pension earnings upon death (where no reversionary beneficiary) would be taxed, effective from 1 July 2007. On the face of it, we could potentially have 5 years of tax uncertainty for family members of deceased fund members.
Fortunately, the ATO issued a Taxation Ruling (TR 2013/5) detailing when a superannuation pension commences and ceases, which, inter alia, states the following: “This Ruling applies from 1 July 2007….Having regard to the need to allocate compliance resources the Commissioner considers that it is not appropriate for the ATO to take compliance action to apply the views of the law expressed in this Ruling with regards to when a superannuation income stream ceases on the death of a member before the 2012-13 income year.”
Before the 2013 regulations came into effect and confirmed the continuation of the pension tax exemption (see discussion above), there was significant debate over whether the tax exemption on earnings derived from pension assets continued in all circumstances, or whether the pension account reverted to accumulation phase. The ATO argued that when a pension member died and he or she had not arranged for a reversionary beneficiary, there was a strange quirk in the system that meant the pension account reverts to accumulation phase. If the ATO view prevailed, what would that have meant for the family of the deceased? Well, it would mean that when the fund assets were sold, any capital gains would be subject to tax before the proceeds can be paid out as death benefits to beneficiaries. If the beneficiaries are non-dependants (as defined under the tax laws) (such as adult children), then you would expect two tax hits:
- Earnings tax on the sale of fund assets (assuming capital gains)
- Death benefits tax on payment of benefits to non-dependants
Based on the ATO’s earlier interpretation, the implications would have been, even when the benefits are paid to dependants (and then tax-free benefit payments), any tax on capital gains from the sale of fund assets would still be payable where no reversionary beneficiary was in place.
Source: The original source of this tax approach to fund earnings when a pension member dies, was an ATO interpretative decision from 2004, ‘ATO ID 2004/688: Superannuation Exempt income – segregated current pension assets’. Quoting from the ATO decision: “Where a fund ceases to have a current pension liability due to the death of a sole member with no contingent pension payable, the assets cease to be ‘current pension assets’ and the income is no longer exempt pension income. As a result the exemption provided for by section 282B of the ITAA 1936 ceases to apply.”
In July 2011, the ATO released further information on this issue, confirming the 2004 position, in the draft tax ruling TR 2011/D3 ‘Income tax: when a superannuation income stream commences and ceases’. Paragraph 24 of TR 2011/D3 states the following: “A superannuation income stream ceases as soon as the member in receipt of the superannuation income stream dies, unless a dependant beneficiary of the deceased is automatically entitled under the superannuation fund’s deed, or the rules of the superannuation income stream, to receive an income stream on the death of the member.
For example, a married or de facto couple, are members of a SMSF and the trust deed provides that: a member who is in receipt of a superannuation income stream, and when that member dies, the income stream will continue to be paid to their spouse. In this situation, the pension would continue including the tax-exempt status of the pension account. A pension will also be considered to have transferred on the member’s death if a valid binding death benefit nomination is in place at the time of the member’s death, and the nomination entitles the beneficiary (a dependant) to a reversionary pension.
In July 2013, the ATO released its final ruling on the matter. In TR 2013/5, ‘Income tax: when a superannuation income stream commences and ceases‘, the ATO states that a pension entitlement ceases when there is no longer a member who is entitled, or a dependant beneficiary of a member who is automatically entitled, to be paid a superannuation income stream benefit from a superannuation interest that supports a superannuation income stream (paragraphs 14 and 29). If the trustee has the discretion to pay either a lump sum or pension to a dependent beneficiary, the pension ceases on the member’s death, and the account loses its tax-exempt status.
Trish Power’s view
Regular readers of SuperGuide, especially those readers who run a self-managed super fund, would be familiar with the coverage on this website over the past few years regarding the draft ATO ruling on the tax status of pension account earnings when the remaining fund member dies.
The view published in the ATO draft ruling (TR 2011/D3) essentially said, that when a pension member dies, and he or she has not arranged for a reversionary beneficiary, the pension account reverts to accumulation phase. What this means for the family of the deceased is that when the fund assets are sold, any capital gains are subject to tax before the proceeds can be paid out as death benefits to beneficiaries. Alarmingly, the ATO wanted to make this interpretation of the rules retrospective to 1 July 2007.
In an earlier SuperGuide article, I expressed the following opinion on the ATO’s position:
I personally think the current view taken by the ATO is ridiculous, and inconsistent with the principles behind offering superannuation pensions. Death benefits are by definition within the sole purpose test, and form an integral component of the superannuation system. I strongly disagree that ‘when a member dies they no longer have an entitlement to receive superannuation income stream benefits’. Payments to superannuation dependants (including non-dependants, as defined under tax laws) are simply an extension of the pension benefit. Hopefully, some legal eagle within the super industry will successfully argue that the pension account continues (and accordingly the tax-exempt status of the pension account) until a death benefit is paid from the account…”
The federal government obviously agreed with me and introduced regulations to protect the tax exemption on pension earnings until a death benefit was paid, while the ATO has demonstrated impressive pragmatism by stating that the ATO will not pursue compliance action in relation to pension earnings and death benefits before July 2012 and on or after July 2007.
Thank goodness for common sense, because if the ATO’s official position was actively pursued, that is a pension account reverts to accumulation phase before death benefits are paid as a lump sum, such an approach would require some dynamic tax management strategies in retirement. The most obvious strategy is to regularly sell assets during retirement, to reduce the potential capital gains. What made this ATO view even more draconian is that the ATO had made it retrospective to 1 July 2007. Can you imagine the trauma for those Australians who have lost loved ones from July 2007 onwards, and would now have to revisit financial affairs that have been finalised and potentially pay a massive tax bill to the ATO?
In summary, the current super laws are…
Since the start of the 2012/2013 financial year, the pension earnings tax exemption will continue following the death of a pension recipient (whether paid as a lump sum or reversionary pension) until the deceased member’s benefits have been paid out of the fund, provided the benefits of the deceased member are paid out as soon as practicable. From 1 July 2007 until 30 June 2012, the ATO will not pursue compliance action for any tax payable on pension earnings, where a fund member has died and there was no reversionary beneficiary.
For further explanation of how death benefits are treated, check out the following SuperGuide articles:
- Superannuation death benefits and the $1.6 million transfer balance cap
- Superannuation after-life: Beware the dastardly death tax
- Superannuation after-life: Dear Dad, Tax for everything
- Death benefits: Is a binding DBN different from a reversionary pension?
- Estate planning: How can a SMSF live forever?
- Anti-detriment payments banned from July 2017