Estate planning and the $1.6 million pension transfer balance cap

11 August 2017

Money & Life team

Money & Life contributors draw on their diverse range of experience to present you with insights and guidance that will help you manage your financial wellbeing, achieve your lifestyle goals and plan for your financial future.

A look at how the $1.6 million transfer balance cap applies to death benefit pensions, while also considering the various strategic opportunities for clients and the steps planners need to take as a result of these new rules.

This article is for educational purposes only and is no longer available for CPD hours.

One of the biggest impacts of the superannuation changes that took place on 1 July 2017, is the effect on estate planning in super.

In this article, we will:

  • Discuss how the $1.6 million transfer balance cap applies to death benefit pensions;
  • Consider various strategic opportunities for clients; and
  • Discuss the steps advisers need to take as a result of these new rules.

The rules from 1 July 2017

From 1 July 2017, a $1.6 million transfer balance cap limits the total amount of superannuation benefits an individual can transfer into an income stream where earnings are tax exempt (i.e. retirement phase).

The value of a death benefit income stream counts toward the recipient’s transfer balance cap. When and how much is counted depends on whether the pension is automatically reversionary to the beneficiary or not. Further, special rules apply to calculate how much transfer balance cap is available to commence a child account based pension. However, these rules are outside the scope of this article.

Table 1 and Table 2 outline the impact on death benefit income streams commenced before and after 1 July 2017.

Table 1: Death benefit pensions commenced prior to 30 June 2017

Pension type Amount credited to the recipient’s transfer balance account Timing of the credit to the recipient’s transfer balance account
Reversionary The value just before 1 July 20171 The latter of:

– 1 July 2017, and

– 12 months after date of death

Non-reversionary The value just before 1 July 20171 1 July 2017

 

Table 2: Death benefit pensions commenced from 1 July 2017

Pension type Amount credited to the recipient’s transfer balance account Timing of the credit to the recipient’s transfer balance account
Reversionary The value at date of death1 12 months after date of death.
Non-reversionary The value at commencement1 When the death benefit pension commences to be paid

 

Superannuation legislation requires a superannuation death benefit to be cashed as soon as practicable. This can generally be done by cashing out a lump sum, commencing an income stream or a combination. Critically though, a superannuation death benefit cannot be retained in (or rolled back to) an accumulation interest, as this would contravene this regulatory requirement.

Beneficiaries need to ensure that the receipt of a death benefit income stream does not result in them exceeding their transfer balance cap. If a death benefit income stream, in combination with the individual’s own income stream(s), results in a beneficiary exceeding their transfer balance cap, they will need to decide which income stream to commute.

Example: Death benefit income stream, where the beneficiary has used up their transfer balance cap

In July 2017, Yanna commences an account based pension (ABP) with $1 million and her husband Yannick commences an ABP with $1.6 million.

On 31 October 2018, Yanna passes away, leaving Yannick as the binding beneficiary of her remaining ABP, now worth $800,000.

The balance of Yannick’s ABP is now $1.4 million (the value of both their pensions have been reduced over time by the drawdowns of superannuation income stream benefits). Despite this, as Yannick started the superannuation income stream with the full value of his transfer balance cap, he cannot transfer any further amount into the retirement phase without reducing his transfer balance first.

Yannick has two possible options:

  1. Yannick may take Yanna’s superannuation death benefit of $800,000 as a tax-free lump sum, which would have to be cashed out of the superannuation system.
  2. Alternatively, he could partially commute $800,000 of his superannuation income stream back into the accumulation phase. By doing so, this would free up transfer balance cap space, allowing him to take a death benefit income stream of $800,000.Yannick would still have his original superannuation income stream in the retirement phase (now supported by a reduced interest of $600,000) and would also have $800,000 in accumulation. If Yannick chose this option, he would not need to cash any of Yanna’s superannuation interest out of the superannuation system as a death benefit lump sum.

Practical impacts

One of the biggest impacts of super reforms is that in addition to the usual estate planning considerations, advisers now need to take into account the impact of the receipt of a death benefit pension on the beneficiary’s transfer balance cap. That is, advisers must consider both pensioners’ transfer balance accounts to determine how much the recipient can retain in a death benefit income stream.

Self-managed super funds (SMSFs)

Many SMSFs hold bulky assets (e.g. residential and commercial property). Some have limited recourse borrowing arrangements in place to finance these assets. The current estate plan for many of these clients may be for the surviving spouse to commence a death benefit income stream to enable the asset to be retained within the SMSF. For many clients, this may no longer be an option.

Further, as many clients will be unable to keep the total amount of capital in super, a large portion may need to be cashed out. In light of these changes, advisers need to review impacted clients’ current nominations and their overall estate plan. They may need to consider what needs to happen to the asset if it has to be paid out of superannuation. Depending on the client’s circumstances, directing some/all the death benefit to a testamentary trust, or to a non-spouse beneficiary, may need to be considered.

Nomination options

Advisers are often involved in assisting clients to consider whether reversionary, binding or non-binding nominations are most appropriate to their circumstances. The right solution will depend on the client’s situation, their goals and objectives.

One of the advantages of using a reversionary nomination is that it gives the client 12 months to get advice and have things sorted. With non-reversionary pensions, the usual requirement to pay a death benefit as soon as practicable applies. Clients should ensure they seek financial advice as soon as possible to decide on the next steps.

The amount that counts towards the reversionary beneficiary’s transfer balance cap is the pension value at the time of death. For a non-reversionary income stream, the value when the pension is commenced is counted. This can be:

  • advantageous for reversionary pensioners whose pensions increase 12 months later due to positive investment earnings; or
  • a disadvantage for those who experience the opposite.

Importantly, any excess above the reversionary beneficiary’s transfer balance cap can only be cashed out and paid to the beneficiary directly, out of the super environment. This may give an inefficient outcome from a tax, estate planning, asset protection and/or aged care perspective. To avoid this, for some clients, a binding nomination to the spouse and/or other beneficiaries or even a non-binding nomination, in the right circumstances, may be more appropriate.

Ongoing review of a client’s nominations is now more important than ever. In addition to the usual triggers for the nomination reviews (e.g. divorce, marriage, change of beneficiaries’ circumstances etc), advisers will need to consider the changes to clients’ and their spouses’ super and pension account balances.

Example: Reversionary or binding nomination?

In July 2017, Ludmila (age 66) starts an ABP with $1.6 million. Her husband, Igor (age 70), starts an account based pension with $1.5 million.

Igor dies on 31 October 2018, leaving $2 million in his pension. Ludmila’s pension is $1.4 million at that time. Let’s consider the outcome if Ludmila and Igor had:

  1. Reversionary nominations to each other;
  2. Non-binding nominations to each other; or
  3. Binding nominations in place.

Scenario 1: Reversionary nominations to each other

Under this scenario, Igor’s pension automatically reverts to Ludmila, and she will have 12 months to decide what to do next.

She cannot retain the full value of the death benefit income stream in pension phase, as the full value of her transfer balance cap has already been used up. To avoid cashing out the full death benefit:

  1. She could fully commute her own pension back into accumulation,
  2. This will result in a debit in her transfer balance account of $1.4 million, and
  3. Will free up enough transfer balance cap space to retain $1.4 million in the death benefit pension.

Ludmila should take these steps before 31 October 2019, to ensure that she does not exceed her personal transfer balance cap. As a result, $1.4 million of Igor’s pension is retained in the superannuation environment, together with Ludmila’s own funds.

However, the remainder of the death benefit pension (i.e. $600,000) counts towards Ludmila’s personal transfer balance cap on 31 October 2019
(i.e. 12 months after Igor’s death). As this is a death benefit, and therefore cannot be rolled back into the accumulation phase, this amount must be cashed out of the superannuation environment.

Given that Ludmila is a high marginal tax rate taxpayer, this is an inefficient tax outcome.

Scenario 2: Both Ludmila and Igor had non-binding nominations to each other

Igor’s pension ceases on his death, and the death benefit must be paid out as soon as practical. Ludmila seeks financial advice. As a result:

  1. She commutes her own pension (in full) back into accumulation,
  2. This will result in a debit in her transfer balance account of $1.4 million, and
  3. Will free up enough cap space to receive $1.4 million as a death benefit pension.

Igor’s nomination is non-binding. If Ludmila is in a self-managed super fund (SMSF), Ludmila, as the trustee, has the ultimate discretion as to how the benefit will be paid. In a retail fund, she can generally ask the trustee to pay a portion to her and a portion to other SIS dependants and/or the estate.

After seeing her financial adviser, she asks the trustee to pay the death benefit as follows:

  • $1.4 million to her as a death benefit income stream; and
  • The remainder to the executor of Igor’s estate. Igor’s will provides for an optional testamentary trust to be set up with the proceeds. The death benefit is then paid into the testamentary trust and the income and capital are streamed to Ludmila’s children and grandchildren2.

Scenario 3: Ludmila and Igor had binding nominations in place

Non-binding nominations may be inappropriate in some situations. For example, if Ludmila and Igor have children from previous marriages, whom they would like to leave a portion of their superannuation to, then binding nominations would provide more certainty.

So, what should Ludmila and Igor consider when putting a binding nomination in place?

If they have binding nominations to each other, then the outcome will be similar to scenario one. Although, unlike scenario one, there is no 12-month grace period until the value of the death benefit pension is counted towards Ludmila’s transfer balance cap.

If a binding nomination is required, Ludmila and Igor should consider:

  • the proportion that needs to be directed to each other to comply with transfer balance cap rules, and
  • where the remaining proportion needs to go (e.g. adult children, the testamentary trust via the estate etc).

If this option is selected, the nomination will need to be regularly reviewed to ensure that the nominated proportions remain appropriate.

 

Footnotes

  1. The amount of the transfer balance credit is modified for certain defined benefit income streams and term allocated pensions.
  2. The tax on the death benefit must be considered prior to deciding to direct some/all of the death benefit into the estate. A lump sum death benefit paid directly to the spouse is tax-free. When a death benefit is paid to the estate, no tax is withheld by the super fund trustee. However, the executor or administrator of the estate is required to withhold tax according to the tax components and the tax status of the ultimate beneficiary(ies) of the lump sum. Where it is not clear as to who will benefit (e.g. the lump sum death benefit forms part of a discretionary testamentary trust that has both tax dependent and non-dependent beneficiaries), the whole amount is deemed to have been paid to a tax non-dependant and is taxed accordingly.

 

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