In this article, we look at the advantages and disadvantages of various options of structuring the receipt of death benefits in superannuation.

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

When an adviser sits down to discuss life insurance cover with their client, it’s an ideal time to have a more comprehensive discussion about estate planning.

It is well known that binding nominations provide certainty as to who a superannuation death benefit is paid to. Where the client has a partner and young children, we often see binding nominations made in favour of each partner.

Some clients may not realise that alternatives, other than nominating their partner, may be available and that there may be potential tax, asset protection and Centrelink advantages in considering these options.

These alternatives can be particularly important to discuss where life insurance is held within the superannuation fund, as the potential payout can be significant.

As a starting point, it is crucial that the client understands that their superannuation death benefits (including life insurance proceeds) can only be paid directly from the superannuation fund to someone who is either their superannuation dependant or legal personal representative (LPR). The only exception is in the rare situation where no superannuation dependant or LPR exists.

A superannuation dependant is defined in superannuation law and is also referred to as a SIS dependant. SIS dependants include:

• the deceased’s spouse (including same or opposite sex de facto) but not a former spouse;
• the deceased’s child of any age;
• any other person who was financially dependant on the deceased just before he or she died; and
• any other person with whom the deceased was in an interdependency relationship just before he or she died.

Under a valid binding nomination, the trustee is bound to pay to the nominated SIS dependant or the nominated LPR of the estate.

Once the funds are received there are generally very limited, if any, planning opportunities to tax-effectively transfer the assets to another person or entity.

This is why a comprehensive discussion in the planning stage can be beneficial, and should include an outline of:

• all the client’s beneficiaries who are able to be nominated;
• various forms in which the death benefit can be received by those beneficiaries; and
• the advantages and disadvantages of each option.

Case study: Nomination options

Melissa and John (both in their 40s) are married and have two children. Linda (age 12) and Ben (age 10).

John works as a financial analyst, earning $110,000 per annum, and Melissa works as a graphic designer, earning $70,000 per annum. Apart from their family home, owned as joint tenants, the couple have no other significant assets.

Following their financial planner’s recommendations, John and Melissa take out life insurance through their respective superannuation funds and also execute binding nominations to each other.

Sometime after this, Melissa is diagnosed with a brain aneurism and passes away within two months of diagnosis.

The trustee of Melissa’s superannuation fund, in accordance with her binding nomination, pays her death benefit of $770,000 (an accumulation account of $120,000 and life insurance of $650,000) to John as a tax-free lump sum.

In addition to Melissa’s accumulation and life insurance proceeds, John also receives an anti-detriment payment of $21,180*, bringing the total tax-free death benefit to $791,180.

* Using the ATO formula method, where a member’s eligible service period in the fund is after 30 June 1988, the gross anti-detriment payment will always be 17.65 per cent of the taxable component (less insurance proceeds).

An anti-detriment payment is a ‘top up’ payment, made in addition to the death benefit by some

superannuation funds. It broadly represents a return of contributions tax paid. It is only available on the portion of the death benefit received as a lump sum by a spouse, former spouse or child of any age. The anti-detriment payment is calculated on the taxable component of the death benefit only, excluding any insurance proceeds.

* It should also be noted that as part of the 2016 Federal Budget announcement, the Government has proposed to remove the anti-detriment deduction from 1 July 2017. This proposal is not yet law.

Once John has repaid the home loan, he invests the remaining amount (around $500,000).

As John continues to work, he pays tax on the earnings at his marginal tax rate of 39 per cent, including Medicare levy.

If we assume a six per cent earnings rate, John’s investments will produce $30,000 per annum. John will pay tax of $11,700 (ie, $30,000 x 39 per cent), leaving a net amount of $18,300.

John cannot invest these funds in the children’s names tax-effectively at this stage. If any of these funds are invested on behalf of Linda and Ben, the penalty tax rates applicable to passive income earned by minors will apply, with no access to the Low Income Tax Offset (LITO).

Assuming that the fund rules allow it, John can instead elect to start a death benefit pension with Melissa’s death benefit. A death benefit income stream can be paid to:

• the deceased’s spouse (including de facto and same-sex partner);
• the deceased’s child under age 18, or aged 18 to 24 (inclusive) and financially dependent on the parents at the time of death;
• the deceased’s child of any age where the child is permanently disabled;
• any other person who was financially dependent on the deceased at the time of death; and any other person with whom the deceased had an interdependency relationship at the time of death.

As both Melissa and John are under age 60 at the time of her death, the income payments will be taxed at John’s marginal tax rate less a 15 per cent tax offset. As John continues to work full-time and earns other income, this option does not achieve the most tax-effective outcome.

Further, John will lose the anti-detriment benefit payment of $21,180 because it is not payable where a death benefit is taken as a pension.

Three years down the track, John enters into a de facto relationship with Lucinda, who has two young children of her own.

This relationship subsequently breaks down and in settlement, Lucinda receives a significant portion of the remaining investments, depriving John and his children, Linda and Ben, of part of their inheritance.

What other options could have been considered?

A number of alternative nomination options could have been discussed with John and Melissa.

A portion of the death benefit could still be directed to the surviving spouse to repay the mortgage, but other options for the remaining amount could also be considered, including:

1. Nominating the children – lump sum

Upon Melissa’s death, Linda and Ben can receive their portion of the death benefit as a tax-free lump sum. A full anti-detriment payment will be payable on that amount*1*.

The funds can subsequently be invested for the children. John will be the legal owner of the investments on Linda and Ben’s behalf until they turn 18.

However, Linda and Ben, as beneficial owners, will be taxed on the investment income derived. Because the source of the funds is the superannuation death benefit paid directly to the children, child penalty tax rates will not apply to this income.

2. Nominating the children – death benefit income streams

Upon Melissa’s death, assuming the fund rules allow this, Linda and Ben can start child account based pensions with their portion of the death benefit.

3. Nominating the executor of the estate – testamentary trust

This option involves nominating the LPR (eg, the executor of the estate) to receive the remaining death benefit.

John and Melissa’s wills need to be updated to establish a discretionary testamentary trust with the superannuation proceeds.

Upon Melissa’s death, John, as the trustee, can distribute income to the children and/or himself. Income is taxed at adult rates, rather than penalty rates, if distributed from a testamentary trust to minor children.

Under this option, using the facts of the case study, it is likely that no tax would be payable on the investment earnings/trust distributions in the hands of the children.

What is the optimal solution?

The optimal solution depends on the client’s specific circumstances. There is no ‘perfect’ solution and each alternative has benefits and drawbacks.

The planner’s role is to educate the client on the options available to them and various issues to consider.

The client, based on his/her goals, and if required, in consultation with the estate planning lawyer, will make a decision on the most suitable way to structure their beneficiary nominations.

After understanding the options available to them, John and Melissa may decide that a combination of the above options may be best for them. For example, John and Melissa may nominate:

• a percentage of the death benefit directly to each other. When one of them dies, the death benefit can be received as a tax-free lump sum. The anti-detriment payment will also be available on this amount.
• a small percentage of the death benefit directly to the children. Upon the parent’s death, the surviving member of the couple will seek advice and may decide to elect to start child account based pensions for Linda and Ben.
• a large percentage of the LPR (the executor of the estate). They will then update their wills to set up a discretionary testamentary trust with the superannuation proceeds. The surviving parent can control the trust and distribute income tax-effectively to the children. They can also decide on the appropriate age for the children to access the remaining capital and gain control of the trust.

The advantage of this blended approach is that it gives John and Melissa a mixture of asset protection, tax effectiveness and control.

Constant review is paramount

Even if the client’s superannuation funds offer non-lapsing binding nominations, planners need to consider whether their nomination is appropriate at every review.

Clients’ circumstances change and this often requires modifications to the nominated beneficiaries/percentages allocated.

Examples of changes that should trigger an immediate review of the beneficiary nominations include:

• children turning age 18 and becoming financially independent;
• marriage or entering a de facto relationship;
• separation, divorce or ending a de facto relationship; and
• change in debt levels.

Footnote

1. As part of the 2016 Federal Budget announcement, the Government has proposed to remove the anti-detriment deduction from 1 July 2017. This proposal is not yet law.