With Division 296 now part of the super landscape, many advisers are revisiting long-standing estate planning arrangements and asking whether clients should remove their spouse as a reversionary beneficiary to help manage future Division 296 exposure.
It's a fair question. A reversionary pension can increase a surviving spouse's total super balance (TSB), potentially increasing future Division 296 tax exposure. But focusing on Division 296 alone can mean overlooking a range of other planning considerations.
In many cases, retaining a reversionary pension nomination may still be the better outcome but it does depend on what the client is trying to achieve.
Consider Michael and Steph. Michael has a TSB of $4.8 million and Steph has a TSB of $4.5 million. Both have account-based pensions and have nominated each other as the reversionary beneficiary.
If Steph survives Michael, the balance of Michael’s reversionary pension counts towards Steph’s TSB from Michael’s date of death. As a result, when Steph’s TSB is measured at the following 30 June, it will have increased from around $4.5m to over $9m.
From a Division 296 perspective, this outcome isn't particularly attractive. The increase in Steph’s TSB will mean a greater proportion of the fund’s Division 296 earnings are exposed to the tax.
The impact may be even more significant where the surviving spouse is below the Division 296 threshold. For example, if Steph’s TSB was $2.5 million instead, Michael's death benefit pension could increase her TSB to $7.3 million, taking her from below the threshold to well above it.
A non-reversionary pension may provide greater flexibility because the survivor's TSB does not automatically increase on their spouse’s death. Instead, any increase will generally occur later if and when a new death benefit pension is commenced.
That sounds compelling from a Division 296 perspective. But it's only one piece of the puzzle.
One of the biggest advantages of a reversionary pension has always been certainty.
When a member dies, the pension automatically continues to the nominated beneficiary. There is no trustee decision required and less scope for disputes about who ultimately receives the benefit.
This can be particularly valuable in blended family situations or where control of the SMSF may become contentious after death.
By contrast, a non-reversionary pension provides flexibility. That flexibility can be useful, but it also means more decisions need to be made after death. Depending on the circumstances, that may be a benefit or a burden.
The key question is whether the client values certainty of outcome or flexibility to respond to changing circumstances.
When discussions focus on Division 296, it's easy to overlook the transfer balance cap (TBC) consequences.
With a reversionary pension, the credit to the survivor's transfer balance account (equal to the value of the pension account at date of death) does not arise until 12 months after the member's death. Importantly, any investment growth or insurance proceeds received during that period do not increase the TBC credit.
For example, if a pension is worth $2 million at death and grows to $2.3 million over the following year, the reversionary beneficiary’s TBC credit is still based on the original $2 million value.
That's a very valuable outcome.
Of course, the reverse can also be true. If markets decline after death, a non-reversionary pension would have been preferable because any new death benefit pension will generally be credited to the survivor's TBC based on the lower value at commencement.
In other words, whether a reversionary pension is advantageous may depend on what happens to the underlying assets after death.
Another factor that shouldn't be overlooked is the treatment of tax-free and taxable components.
With a reversionary pension, the survivor effectively steps into the shoes of the deceased member. The tax-free percentage that applied immediately before death continues to apply to the pension.
This can be particularly beneficial where insurance proceeds are received after death. Those proceeds do not alter the existing tax-free percentage.
The outcome can be less favourable with a non-reversionary pension. If insurance proceeds are received before a new death benefit pension is commenced, they will generally form part of the taxable component, potentially diluting the tax-free percentage of the benefit.
For clients with significant insurance arrangements, that outcome may outweigh any perceived Division 296 advantage.
While a reversionary beneficiary is typically nominated when the pension is commenced, it may be possible for the original pensioner to change a pension from reversionary to non-reversionary (or vice versa) without commuting and restarting the pension. Whether this is possible will depend on the fund's governing rules and the terms of the pension, which must specifically allow for the change.
Any decision to change a pension's reversionary status should be considered carefully, weighing up not only the Division 296 implications but also the broader risks and benefits.
Division 296 has undoubtedly added a new dimension to the reversionary versus non-reversionary pension debate. In some cases, having a non-reversionary pension may provide valuable flexibility around the timing of TSB increases and future Division 296 exposure.
But that doesn't automatically mean reversionary pensions are no longer desirable.
They can still deliver significant advantages, including certainty of outcome, seamless continuation of pension payments, favourable TBC outcomes, and preservation of tax-free proportions.
As with many planning decisions, the right approach will depend on the client's circumstances and objectives. Division 296 is an important consideration, but it shouldn't drive the entire strategy.
Want to learn more about death benefit planning and Division 296 in SMSFs? Join us at our upcoming Death Benefits Masterclass, focused on death benefit planning, or our Division 296 Tax Masterclass, where we'll unpack the new tax and its planning implications. Register here.