By Mark Ellem
Remember those old movies where savages boiled the colonials in a big pot. Failing to consider insurance for fund members could end up with the trustees being boiled in oil by their auditor, the ATO or worse still, a deceased member’s relative.
As a member or a dependant of an SMSF, death benefits that include insurance proceeds require an understanding of the tax consequences and how they can be managed.
The amount of tax levied on such a payment depends on whether a member has any ‘tax dependants’, their ‘eligible service date’ (ESD) and whether the member died before age 65. Trustees should have these details available if a death or disability benefit becomes payable.
Let’s see how tax is impacted by these factors by focusing on life insurance which can be worthwhile to have inside an SMSF for two main reasons:
Life insurance premiums paid on policies held outside superannuation are not eligible for income tax deductions. However, the proceeds from life policies attract no income tax upon death or many other insured events.
Likewise, insurance proceeds paid by the insurer to an SMSF are not taxed in the fund. However, any resulting benefit paid by the fund because of the death of a member are tax free if paid to a ‘tax dependant’ as a lump sum. However, if the lump sum is paid to a ‘non-tax dependant’ the ‘taxable component’ of the lump sum is taxed. The most common case study of a ‘non-tax dependant’ is an adult child of the deceased. However, there may be exceptions to this general rule and an adult child may qualify as a ‘tax dependant’ if they are disabled, in an interdependency relationship or financially dependent on the deceased for support at the time of the member’s death.
Where the proceeds of a life insurance policy are allocated to the deceased member’s superannuation accumulation interest it form’s part of the taxable component of that interest. This occurs by default as the insurance proceeds form part of the member’s taxable component and not included in the tax-free component.
Where a deceased member’s interest is then paid as a lump sum death benefit to a ‘tax dependant’, such as a spouse or under age 18 child, the whole of the amount of the payment (including the insurance component) is tax free. Therefore, a trustee will generally not be required to calculate the tax components or withhold any tax from the payment.
However, where a fund pays a death benefit as a lump sum from the member’s accumulation interest to a ‘non-tax dependent’, for this case study, an adult child, the trustee will need to withhold tax from the benefit payment as follows:
Medicare levy/NDIS will also be added to the withholding, except where the death benefit is paid to the deceased member’s estate.
Where a member’s death benefit does not include any insurance proceeds, the whole of the taxable component of the payment will generally consist of a ‘taxed element’. However, where the death benefit includes insurance proceeds and the trustee has ever claimed a deduction for the cost of the insurance premiums, the taxable component will include a ‘taxed element’ and ‘untaxed element’.
The tax laws provide specific steps to calculate the taxed and untaxed elements of a death benefit lump sum. Generally, the rule of thumb is that the ‘untaxed element’ will approximate the amount of the insurance proceeds, however, this is not always the case. This is best illustrated in the following case study.
Will, aged 41, is divorced with no spouse and has one child aged 22 and not considered a tax dependant. Will has his own SMSF and is the sole member and sole director of the trustee company. The current balance of his member account is $700,000 (including $200,000 tax free amount – personal contributions he has made and not claimed as a tax deduction) and he also has life insurance of $600,000, under the SMSF (the fund has claimed the cost of insurance premiums as a tax deduction).
Will has been a member of his SMSF since 17 October 1997 and died on 12 October 2017 which covers a period of 7,300 days. The number of days to Will’s 65th birthday from the time of his death is 8,395 days. Using Will’s current accumulation balance of $700,000 (including $200,000 tax free amount), together with insurance proceeds of $600,000, there is a total benefit payment of $1.3m to his adult child (Will had in place a valid binding nomination to direct the SMSF trustee to pay his adult child the whole of his death benefit).
In determining the tax applicable to the lump sum death benefit payment, we need to calculate the taxable and tax-free components. Further, as the fund has claimed a tax deduction for the cost of insurance premiums, the taxable component will be required to be split between the ‘taxed element’ and the ‘untaxed element’. Applying the relevant rules, the components of the lump sum death benefit payment and applicable tax is as follows:
|Benefit component||Benefit amount||Tax rate||Tax levied|
|Tax free amount||$200,000||0%||$0|
|Taxable component – taxed element||$404,651||17%||$68,791|
|Taxable component – untaxed element||$695,349||32%||$222,512|
The additional five-year service period reduces the tax liability to a ‘non-tax dependent’ by $22,675. Again, you can see that the untaxed element does not equate to the insured amount.
In this case study, Will’s service period could have been extended where it was discovered that he had an eligible service date (ESD) five years earlier. This could occur where Will had rolled over superannuation from another fund to his SMSF and that other superannuation fund had an earlier ESD. A member can effectively transfer an earlier ESD from one superannuation fund to another simply by transferring just $1 of the amount accumulated in that superannuation fund. Therefore, it is important to ensure that SMSF trustees (and the fund’s accountant/administrator) have recorded the earliest ESD for members, particularly in this situation of a member with no tax dependents and insurance held within the SMSF. A member with a large service period will have relatively less ‘untaxed element’ than another member of the same age with a shorter service period. A worthwhile task would be to review for any roll overs into the fund to ascertain if any had an earlier ESD. This will be found on the rollover benefits payment form that would have accompanied the rollover payment.
It is also worth noting that once a member turns 65, they cannot have an ‘untaxed element’ in a death benefit lump sum paid to a ‘non-tax dependent’. This is due to the formulae used including future service days only up until what would have been the deceased’s 65th birthday.
So, would it have been better (for Will’s adult child) for his insurance to have been held outside of his SMSF or in another superannuation fund due to the ESD?
As they say, questions are sometimes easier to answer with the benefit (no pun intended) of hindsight. However, as part of the preparation of a client’s annual SMSF financial statements and return, it would be worthwhile to enquire, if not already known, whether members, with life insurance cover, have ‘tax dependants’. Where they do not, do they understand the personal income tax consequences (for the intended beneficiary) of a lump sum death benefit payment to a ‘non-tax dependant’? This could lead to a review by an appropriate qualified and licensed adviser as to whether such insurance should continue to be held and if so, whether it should be held inside the SMSF or transferred outside superannuation. By doing this, the SMSF trustee(s) are also meeting their obligation under the super law to regularly review the fund’s investment strategy including insurance.
Trustee’s lesson for today: Don’t end up in the pot and get boiled in oil just because you’ve failed to understand insurance and super.