Legislative fix proposed to address challenges with rolling over death benefits

13 Jan 2020

Meg Heffron

Managing Director

A key change introduced in the major 2017 amendments was a new ability to rollover death benefits. But a gap in the legislation made this unworkable for some. A legislative fix was finally tabled in parliament in the final sitting days of 2019.

The change was designed to allow (say) an individual who inherited their spouse’s superannuation in Fund A to transfer this to a new fund (Fund B) without leaving the superannuation system. Until then, death benefits were specifically prohibited from being rolled over which meant all sorts of sensible strategies were impossible. Someone inheriting a spouse’s superannuation:

  • in an SMSF could not choose to wind up the SMSF and transfer the inheritance to a new fund
  • in an industry fund could not transfer it to the industry or retail fund to which they already belonged

And more.

The new rules allowed a seamless rollover process providing the beneficiary was an individual who was allowed to receive the death benefit as a pension (generally the spouse or minor children) and providing they commenced a pension immediately in the new fund.

But there was a snag.

Sometimes, doing exactly what the law was intended to allow created a huge tax bill for unwitting beneficiaries.

The problem lies in the way in which tax components are defined.

When an individual dies, their super is broken up into components as follows:

  • a tax free component (the usual inclusions – non-concessional contributions, downsizer contributions etc)
  • a taxable component (everything else) which is further divided into: a taxed element and an untaxed element.

Most of us get through life without ever having an untaxed element – it’s usually reserved for people who belong to funds that don’t pay tax (eg funds for public servants that are funded by the Government directly). The idea is that when these people eventually take their super, they pay extra tax on this “untaxed element” to reflect the fact that their super hasn’t been reduced by tax over the years it was building up.

The other time an untaxed element is created is when someone under 65 dies and:

  • the benefit is paid as a lump sum
  • it includes an insurance payout
  • the fund has claimed a tax deduction for either the insurance premiums along the way or another particular type of tax deduction when the member dies.

(There are also times when this untaxed element can arise even if no insurance pay out was included in the benefit but the above is the most common scenario.)

If that happens, a formula is used to work out how much of the taxable component should be an untaxed element. For people who die young, the amount can be very significant as a proportion of their total benefit although it tapers off and reaches $nil for people who die at 65 or older.

The untaxed element is then taxed at a higher rate than the taxed element.

In the past (and this was the intention of the law) this untaxed element only affected benefits paid to people who were not “death benefit dependants” (individuals who are considered dependants of the deceased for tax purposes). The way the rules worked was:

  • even though this untaxed element technically existed for (say) a death benefit paid to the surviving spouse, as a death benefits dependant they were entitled to receive the whole benefit tax free regardless. We could effectively ignore the fact that an untaxed element even existed
  • many death benefits dependants were allowed to take the benefit as a pension if they chose to – for example, the surviving spouse, minor children. If they did so, the untaxed element was never created (it happens exclusively when a death benefit is received as a lump sum)
  • if anyone else (not a death benefits dependant) took the benefit, they had to take it as a lump sum. The untaxed element would be calculated and it would be taxed at a higher rate than the rest of the taxable component (30% rather than 15%, plus medicare if applicable).

Allowing death benefits dependants who can take their inheritance as a pension to rollover from one fund to another was never intended to change this treatment.

But there was a flaw in the legislation.

When anyone rolls over a superannuation benefit, the rollover is a lump sum. Of course, it’s not normally taxed when it’s taken out of Fund A because the money is still in the “superannuation system”. Normally, rollovers are also not taxed when they are received by Fund B – because this is not new money to the superannuation system.

But untaxed elements are taxed when received by their new superannuation fund.

Looking at this through the lens of (say) a public servant who rolls their money out of a government fund into an industry fund this makes perfect sense. Their super hasn’t been taxed along the way. If they took a lump sum or pension directly from their government fund, they would have to pay extra taxes to reflect this. It therefore makes total sense that if they transfer their super to a normal “taxed” fund, they should have to pay some tax on arrival, otherwise they could completely avoid any extra taxes.

But looking at this through the lens of a death benefit rollover it creates a problem.

A death benefits dependant who inherits (say) their spouse’s super in Fund A but wants to move to Fund B and start a pension will ask for a rollover between the two funds. A rollover is a lump sum. It will therefore trigger the calculation of an untaxed element. Currently the law can’t tell the difference between an untaxed element calculated under these circumstances and one calculated because the member has been in a Government fund. The receiving fund therefore has to tax it. And the tax bill can be huge. Left unchanged, it would make it virtually impossible for anyone inheriting superannuation from (say) a spouse aged well short of 65 to take advantage of the new rule.

That makes no sense.

After several years of harassment from industry, the Government has finally put forward a bill to fix the problem.

It will specifically exclude untaxed elements created by deaths from being taxed in Fund B and will be backdated to 1 July 2017 (ie when the law was changed to allow death benefit rollovers).

Long overdue but eminently sensible. Let’s hope it’s passed quickly when Parliament sits again in February 2020.