This article examines the advantages and disadvantages of various options of structuring the receipt of superannuation death benefits.

When an adviser sits down to discuss life insurance cover held within superannuation with their client, it is also an ideal time to have a comprehensive discussion about estate planning.

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

It is well known that binding nominations provide certainty as to whom 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 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 client’s super 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 generally only be paid directly from the superannuation fund to someone who is either their superannuation dependant (SIS 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 dependent 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 then 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;
• the 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 adviser’s recommendations, John and Melissa take out life insurance through their respective super 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.

The trustee of Melissa’s super 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.

When considering the options available to John, it is important to remember that since 1 July 2017, a death benefit can:

• only be paid as a lump sum, an income stream, or a combination of the two;
• be rolled over to a different provider to immediately commence an income stream; and
• never be rolled back and retained in the accumulation phase. That is, the entire death benefit must be received as a lump sum or a pension.

Option 1: Total death benefit received as a lump sum

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 the Medicare levy. If we assume a 6 per cent earnings rate, John’s investments will produce $30,000 per annum. John will pay tax of $11,700 (i.e., $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 (see Table 1), with no access to the Low Income Tax Offset (LITO) and Low and Middle Income Tax Offset (LMITO).

Table 1

Option 2: A portion of the death benefit received as a lump sum, the remainder as a death benefit income stream

Alternatively, John may elect to start a death benefit pension with some or all of 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 parent 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.

Importantly, the value of a death benefit income stream will count towards John’s transfer balance cap on the day the income stream is commenced.

As both Melissa and John are under age 60 at the time of her death, the taxable component of 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.

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, including some of the death benefit income stream, 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:

Alternative option 1: Nominating the children – direct payment of a lump sum

Upon Melissa’s death, Linda and Ben can receive their portion of the death benefit as a tax-free lump sum. The funds can subsequently be invested for the children.

John would 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 (see Table 2).

Table 2

Alternative option 2: Nominating the children – death benefit income streams

Upon Melissa’s death, Linda and Ben can start child account based pensions with their portion of the death benefit (see Table 3).

Note: Special rules apply to calculate how much transfer balance cap is available to commence a child account based pension – these rules are beyond the scope of this article.

Table 3

Note: There is a technical argument that there is no option to make partial lump sum commutations from a child account based pension. Therefore, if a commutation is made, the entire account balance needs to be commuted. Advisers should check their product provider’s view on this prior to recommending a commutation from a child account based pension.

Alternative option 3: Nominating the executor of the estate – testamentary trust

This option involves nominating the LPR (i.e. 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 super 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, given 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 (see Table 4).

Table 4

 Alternative option 4: A non-binding nomination

There may be circumstances in which a non-binding nomination may be an appropriate option to consider. If the trustee allows alteration to the direction of the payment from the non-binding nominee, it may allow a more tax-effective outcome.

Under this option, Melissa and John nominate each other via non-binding nominations. Once Melissa passes away, John can seek advice on the optimal way of structuring the payment of the death benefit, based on the family’s circumstances and tax and superannuation rules at that time.

There are a number of risks associated with this strategy. For example, another SIS dependant could appeal to the trustee to be paid the benefit and the end outcome may not align to the deceased member’s wishes. This also relies heavily on the trustee of the superannuation fund allowing the type of flexibility discussed. Even if the benefit eventually ends up with the member’s desired beneficiaries, the process taken by the trustee to ascertain the most appropriate recipient can be time consuming.

Therefore, the use of a non-binding nomination can sometimes be more appropriate in a non-blended family situation in a self-managed super fund (SMSF), rather than a retail (public offer) fund.

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 adviser’s role is to educate the client on the options available to them and various issues to consider. The clients, based on their 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 – potentially providing them with a mixture of asset protection, tax effectiveness and control.

Alena Miles, Technical Strategy Manager, AMP.

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QUESTIONS

Take the quiz here.

1. The appropriate death benefit nomination depends on the client’s circumstances.

a. True.
b. False.

2. Nicole is due to receive a death benefit from her deceased husband under a binding nomination. She is deciding how to deal with the proceeds. Which of the following is correct?

a. Nicole can ask the super fund to pay a death benefit pension to her six-year-old daughter instead of herself.
b. Nicole can ask the super fund to retain the death benefit in super accumulation phase.
c. If Nicole takes the benefit as a lump sum and invests it outside of super, she will pay tax on the earnings at her marginal tax rate.
d. Nicole can take the death benefit as a lump sum and invest it in her six-year-old daughter’s name, with the earnings being taxed at adult tax rates.

3. Which of the following is not an advantage of a testamentary trust?

a. Income distributions are taxed at adult rates in the hands of minors, with the full benefit of the Low Income Tax Offset and Low and Middle Income Tax Offset.
b. Possible asset protection from marriage/de facto relationship breakdown for the beneficiaries.
c. Asset protection from creditors for the beneficiaries.
d. Protection of the assets from the claims against the deceased estate.

4. Putting life insurance cover in place is also an ideal time for advisers to have a comprehensive estate planning discussion with their clients.

a. True.
b. False.

5. Which of the following statements is correct?

a. It is possible for a superannuation death benefit to be paid as a combination of a lump sum and pension.
b. Superannuation death benefits paid as a pension will not be counted towards the recipient’s transfer balance cap.
c. A child account based pension must be commuted to a lump sum when the child turns 18.
d. A superannuation death benefit cannot be paid to a beneficiary who is a child.