Explained: How to reduce tax when paying super death benefits

Taxes comes first, then death. But not when it comes to paying lump sum super death benefits to non-dependants. If your beneficiaries are adult financially independent children, then they are going to be taxed up to 17 per cent on receipt of the super death benefit.

One way to reduce this tax to zero is by implementing a recontribution strategy, and it won’t upset the Australian Taxation Office (ATO).

This step-by-step guide will help you to understand and apply the recontribution strategy.

Why are some of your super benefits tax free and some taxable?

That depends on the types of contributions that make up the balance of your super and whether tax was paid on them.

The first type of contribution is the non-concessional (after-tax) contribution, which is made from income after you have already paid tax on it. These are tax free when withdrawn.

The second type of contribution is the concessional (before tax) contribution, which is made from income before you paid tax on it. These include employer contributions, salary sacrifice contributions and personal contributions that allowed you to claim a tax deduction. These are taxable on withdrawal.

What is a super death benefit?

Superannuation paid after a person’s death is called a super death benefit. Superannuation law sets out who a death benefit is payable to, while taxation law sets out how the benefits will be taxed.

On your death, super death benefits paid to a dependant (for tax purposes) is tax free. A tax dependant includes a spouse or de facto spouse, a former spouse, a child under 18, a person in an interdependency relationship with the deceased, and any other person dependent on the deceased.

But amounts paid to non-dependants, such as adult children, will be taxed at a maximum rate of 17 per cent, including the Medicare levy.

There is a way to effectively eliminate this tax by converting the taxable component into a tax-free component. It’s called the recontribution strategy, and here’s how it works.

How a recontribution strategy works

Generally, your super benefit will include a tax-free and a taxable component. Super that is tax free when withdrawn is known as the ‘tax-free component’ and super that is taxable when withdrawn is known as the ‘taxable component’.

Your super provider will calculate the components of the super death benefits payout based on the proportion of components that make up your total super balance. The fund will tell you how much is tax free and how much is taxable when it receives an application for withdrawal. You can’t choose which component to draw from.

The aim of the recontribution strategy is to minimise tax of super death benefits for non-dependants.

There are two key steps to implement this strategy. The first step is to withdraw an amount from the taxable component of your superannuation benefits and recontribute the same amount as a non-concessional (after-tax) contribution back to superannuation. The recontributed amount will become a tax-free component, which, if paid to adult children on your death, would be tax free.

A case study

The recontribution strategy is best illustrated with the following example.

Emily, age 60, is a retired widow with an adult son, Gary, who is non-dependant. Her superannuation balance is $165,000, all taxable component. She has nominated Gary as the sole beneficiary of the fund on her death.

Step 1: Withdraw the full amount of $165,000. As she has retired and is over the age of 60, she has satisfied a condition of release and can withdraw her super tax free.

Step 2: Make a non-concessional (after-tax) contribution of $165,000 back to super. She’s able to contribute back to super using a bring-forward rule and is not subject to a work test as she is under 74.

The outcome of the recontribution is that the $165,000 would become tax free when paid to her adult children on her death.

If she doesn’t implement a recontribution strategy and dies leaving the $165,000 super death benefit to Gary, it will be taxed at 17 per cent, which is $28,080 including the Medicare levy.

Issues to consider

Three important issues to consider prior to implementing the recontribution strategy include:

• Are you able to access a lump sum benefit? This requires you to satisfy a condition of release such as retiring after preservation age or reaching age 65.
• Are you able to contribute to superannuation? There are contribution rules you need to be aware of.
• Do you have available non-concessional contribution cap to avoid an excess contribution tax?

Get advice

If you believe the recontribution strategy may benefit you, consult a financial adviser to best understand the rules and how they apply to you. With the right guidance, you can eliminate unnecessary tax on super death benefits paid to non-dependant beneficiaries.

See the ATO explanation of tax on super benefits here.

Will you be sure to avoid a tax bill on any super bequest you make? Why not share your suggestions in the comments section below?

Also read: Superannuation work test

Disclaimer: All content on YourLifeChoices website is of a general nature and has been prepared without taking into account your objectives, financial situation or needs. It has been prepared with due care but no guarantees are provided for the ongoing accuracy or relevance. Before making a decision based on this information, you should consider its appropriateness in regard to your own circumstances. You should seek professional advice from a financial planner, lawyer or tax agent in relation to any aspects that affect your financial and legal circumstances.