Can an SMSF claim a future service deduction? 8 traps to watch for

When insurance is held inside a superannuation fund, most trustees automatically claim a tax deduction for the insurance premiums paid each year. But there's another option that is often overlooked. Rather than claiming a deduction for premiums, an SMSF can elect to claim a deduction when a death or disability benefit is ultimately paid.

While the concept of claiming a deduction may seem straightforward, applying the future service deduction rules in practice can be far more challenging. Over the years, we've seen trustees and advisers caught out by some of the finer details. 

Here are eight of the most common traps to understand and avoid. 

But first – what is the future service deduction? 

The future service deduction does not increase the benefit paid by the fund when a member dies or becomes disabled. 

Instead, it creates a tax deduction for the fund. In simple terms, the deduction is based on the portion of a death or disability benefit that relates to the member's future service period. The younger the member, the larger the potential deduction is likely to be because more future service days remain until the special age of 65. 

The deduction is only valuable if the fund will have future taxable income against which it can be used. It's also worth checking the trust deed first. The deed must permit the strategy and if it does, the deduction may still be available even if premium deductions were claimed in previous years. 

An example – how the future service deduction works

George dies at age 50 with a total death benefit of $2 million, including insurance proceeds. Rather than claiming a deduction for the $2,000 insurance premium paid during the year, his surviving spouse, Frances, and their adult son Daniel elect to claim the future service deduction. As George had 25 years of service and 15 years of future service to age 65, the SMSF can claim a deduction of $750,000 ($2 million × 15/40 years). While the deduction does not increase the death benefit paid or change its tax components, it gives the SMSF a significant deduction that can offset current and future taxable income and capital gains tax, with any excess tax losses carried forward to future years. 

Now that we've covered how the future service deduction works, let's look at eight common future service deduction traps. 

1. It’s one or the other – you can’t have both 

The future service deduction is an alternative to claiming a deduction for insurance premiums in the year the benefit is paid. 

Trustees must choose between: 

• claiming a deduction for the premium paid during the year, or 
• claiming the future service deduction instead. 

The decision should take into account the fund's current and future tax position, member ages and likely beneficiaries. 

2. The election is irrevocable and applies to everyone

Once the election to claim future service deductions is made, it's permanent. The choice applies across the entire fund, covering all members and all future years. There is no ability to switch back later.

This is one reason the strategy is generally only relevant in the SMSF environment and even then, it remains uncommon. 

3. It’s not just available on death

Many assume the deduction is only available for death benefits. It may also apply where a benefit is paid due to: 

• terminal illness,

• permanent incapacity, or

• temporary incapacity. 

For temporary incapacity, the relevant amount is generally the income protection payments made during the year. 

In other words, don't dismiss the future service deduction simply because the member survived the event. 

4. Don't overlook the employment termination requirement

For death, terminal illness and permanent incapacity benefits, the payment must arise because employment ceased because of the relevant event. SMSF auditors will often seek evidence of termination, such as an employer declaration, termination letter or final payslip.  

We recently had a case where a terminally ill member commenced a superannuation pension before formally ceasing employment. Because the pension was not commenced in consequence of employment termination (rather it commenced because the member satisfied the terminal illness condition of release), the future service deduction wasn't available. The lesson is not to be too quick to start a pension – the sequencing of events matters. 

5. The fund needs surviving members and future taxable income 

A future service deduction can be substantial, but it only has value if it can be used.

The strategy generally works best where younger members remain in the fund and future taxable income is expected. By contrast, it may provide little or no benefit where: 

• there are no surviving members,

• all remaining members are in retirement phase, or

• the fund is likely to be wound up. 

 Put simply, a deduction that can never be used isn't much of a strategy.

6. Timing matters: a premium must be paid in the same year 

Premium timing can create unexpected problems. 

If an insured member dies before the annual premium falls due, no premium may be paid during that financial year. The ATO's view is that a premium must be paid in the same year the benefit is paid. If not, the future service deduction may not be available. 

Regular premium payments can help reduce this risk. Where annual premiums are used, moving the policy anniversary date to early into the financial year (ie July) can make the difference between qualifying for the deduction and missing out altogether. 

7. Don't forget about the untaxed element 

Whether the fund claims premium deductions or a future service deduction, either choice can result in part of a death benefit becoming an untaxed element. 

This is most relevant where: 

• the member dies before age 65,

• insurance was in force at death,

• the benefit is paid as a lump sum to a non-tax dependant, and

• insurance-related deductions will or have been claimed by the fund. 

Where those conditions are met, part of the death benefit may be taxed at higher rates in the hands of the beneficiary. 

In some cases, not claiming insurance deductions can actually produce a better overall family outcome because it avoids creating an untaxed element altogether. That said, where the benefit is paid to a tax dependant, or the member dies after age 65, the untaxed element rules no longer apply. 

8. Be careful when implementing rollover strategies 

One factor used in calculating the future service deduction is the member's service period. 

When benefits are rolled between funds, an earlier eligible service date (ESD) can be transferred to the receiving fund. For members with insurance inside superannuation, that can have important consequences. 

For life insurance, an earlier ESD can reduce the untaxed element on a future death benefit paid to a non-tax dependant. For total and permanent disability (TPD) insurance, however, an earlier ESD can actually work against the member by increasing the taxable portion of a future disability benefit and potentially leave the member paying more tax if they become permanently incapacitated before age 65.

This issue commonly arises where members use rollovers to fund premiums for a policy held in an insurance-only superannuation fund. Once an earlier ESD is transferred, it generally cannot be undone. For members concerned about TPD outcomes, funding premiums via contributions rather than rollovers may be worth considering. 

Final thoughts 

The future service deduction can be a valuable strategy, but only where the rules are carefully navigated. Understanding these common traps before a claim arises can help ensure the deduction is available when needed and avoid unintended tax outcomes for both the fund and its beneficiaries. 

Get SMSF help when you need it with Heffron's Super Companion, an expert-written, online resource hub containing guidance, examples, and strategies for everything SMSF. Learn more here.