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Self Managed Super Fund (SMSF) Article
Death benefits paid a pensions
By Tony Negline.
This article may be out of date.
14th September 2005
Anyone who wants to provide adequately for their loved ones needs to know how the super and tax systems can help hinder their objectives.
In this article we will look at an example of a couple still many years away from retirement.
John and Kerrie Young have four primary school age children. John is aged 40 and a successful architect. Kerrie is 41 and runs the house and also helps in John's office.
Their home mortgage, credit card debt and margin loan total about $600,000. Their current lifestyle costs them $80,000 after-tax. Like most younger Australian families the income just covers the outgoing expenses.
John is the main bread winner, so his income earning capacity has to be protected. Unfortunately many people also foolishly ignore what might happen financially if Kerrie were to die or become permanently disabled.
The Young's decide that John's life should be insured for $1.5 million and Kerrie's life for $500,000.
If John died and the life insurance was in his John's super fund, how should it be paid? Lets assume that in John's super fund he currently has an account balance of $100,000. Of this amount $10,000 are undeducted contributions. Therefore on his death, his super fund trustee would have to distribute $1.6 million. John doesn't have a Transitional RBL.
Most super fund trust deeds allow a death benefit to be paid as a lump sum. Under normal tax law, if a super fund death benefit is paid as a lump sum, it is assessed against the deceased's pension RBL. If that death benefit is paid to Kerrie or any of their children – or is paid to them via John's estate – then the benefits will be paid tax-free for the first $1,297,886 which is John's pension RBL this year. The balance (excluding the undeducted contributions) will be taxed at 48.5%.
This means that the $1.6m lump sum death benefit would be reduced by $141,680 tax, leaving a net benefit of $1,458,320.
On the face of it, this doesn't seem like such a bad outcome. The $600,000 of debt could be extinguished leaving more $850,000 to provide the family's income needs. Is this a sufficient amount for the longer-term? If John died, Kerrie would need $55,000 income (which is less than their current income needs because they no longer have to feed and clothe John or pay off the mortgage and other interest costs). If Kerrie could invest this money and earn $62,000 income per year income (that is about 7.3% return) then she could keep her current lifestyle after paying income tax and receiving the Family Tax Benefit. This is a fairly high level of income to earn each year from investments and therefore the Young's should either increase the amount of insurance or find a better way.
We could pay a lump sum to Kerrie of $600,000 tax-free. This could be used to pay off the outstanding debt. We still have $1 million to allocate.
Some super fund trust deeds would allow us to pay Kerrie a pension. If Kerrie and John have a SMSF then we can only pay her either a Term Allocated Pension (TAP) or an Allocated Pension (AP). (We might like to pay her a lifetime pension but the super laws currently don't allow it.)
Whichever pension we select, it will be assessed against Kerrie's RBL. If she takes an AP it will be assessed against her reduced lump sum RBL of $421,820 ($648,946 reduced by 2.5% for each year she is under 55). This would generate a large excess benefit. Alternatively we could give her a TAP which would be assessed against her pension RBL which is not reduced if the taxpayer is under 55 which means she would not have an excess benefit. In event Kerrie is young and by taking super benefits now she is jeopardizing her retirement planning.
Alternatively we could give the children pensions. Because the children are under 18 the pensions are not counted against anyone's RBL. Lets assume we give each children an allocated pension of $250,000. They must be paid an income between $8,750 and $25,000.
Under normal tax laws, children are taxed very heavily but these rules don't apply to death benefit pensions. In fact, the children would be eligible for a 15% rebate on each pension payment. Based on current tax law they can be paid $25,000 without paying any tax.
Any income paid to the children from the pensions must only be used for their care and not for anyone else. Perhaps in this case, the children could be paid $10,000 each with a smaller initial lump sum. Kerrie would need another $15,000 income to bring the family income up to the required $55,000. Kerrie either needs to take a larger lump sum and invest it outside of super or alternatively has to take a death benefit pension even though it will effect her retirement. However if Kerrie and John have a SMSF and the children are receiving death benefit allocated pensions then the fund will already have four members. Kerrie cannot be a pensioner member as well. How should this membership limitation be handled?
Overall the super route has offered a better result because of the tax efficiencies available. As always careful number crunching is necessary to work out the best solution.
Whilst the children are under 18, Kerrie would have to act as trustee on their behalf. But as each of them turns 18 they must become a trustee. Allocated Pensions can be commuted at anytime so how do you stop young adults getting their hands on any remaining lump sum? This is a tricky issue which we will deal with in another column.
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