Managing tax on life insurance through super
Advisers should consider the tax treatment of holding insurance inside super for their clients, as it will largely depend on whether the recipient is a dependant or non-dependant for tax purposes, Alena Miles writes.
Holding life insurance through superannuation is popular for many clients, and a default position for many of those in employer super plans.
One of the advantages of holding life insurance through superannuation is the ability to use various methods to meet the cost of the premiums, and the often tax effective nature of these funding methods.
However, there are a number of factors that should be considered when holding insurance inside superannuation. One consideration is the tax treatment of insurance proceeds upon payment to beneficiaries. Advisers can add significant value to their clients by explaining the taxation implications of holding life insurance in super and strategic opportunities to manage tax.
The proceeds from a life insurance policy held through superannuation will essentially form part of the deceased member's superannuation death benefit. The tax treatment of a superannuation death benefit will broadly depend on whether:
- The recipient is a dependant or a non-dependant for tax purposes; and
- The form in which the death benefit is paid (i.e. lump sum or income stream).
The following focuses on the possible tax implications of a death benefit paid from a taxed fund in the form of a lump sum.
Death benefit received as a lump sum
The concept of tax dependency is important as it determines how much tax, if any, a beneficiary will pay upon receiving a lump sum superannuation death benefit.
Tax dependants
Lump sum death benefits paid to tax dependants are tax-free, irrespective of the underlying tax components.
Tax dependants include:
- The deceased's spouse, including same or opposite sex de facto, or former spouse;
- The deceased's child aged under 18;
- Any other person who was financially dependent on the deceased just before he or she died; and
- Any other person within an interdependency relationship with the deceased just before he or she died.
Tax non-dependants
On the other hand, tax non-dependants may be subject to tax on a superannuation lump sum death benefit depending on the tax components of the benefit.
A lump sum death benefit paid from a super fund may consist of two components.
1) Tax-free component
2) Taxable component. This component may be further split into two elements:
a) Taxed element
b) Untaxed element
3) The tax rates applicable to a lump sum death benefit received by a tax non-dependant are as shown in Table 1.
Calculating the untaxed element
The untaxed element will arise where:
- The super fund trustee has been claiming a tax deduction for the cost of the insurance premiums; and
- The death benefit is paid as a lump sum to a non-tax dependant.
The untaxed element is calculated using a formula that takes into consideration the amount of the death benefit, including insurance, eligible service period within the fund and age of the member.
Case study
Sam is 58 and has an accumulated superannuation benefit of $300,000, of which $50,000 is a tax-free component and $250,000 a taxable component. He also has life cover of $200,000 in his super fund.
Sam died on 1 January, 2016 and the fund trustee paid Sam's death benefit of $500,000 to his daughter Jessica in accordance with Sam's binding nomination. Jessica, 22, is not a tax dependant of Sam's.
Sam's date of birth is 3 April, 1957 and his eligible service period in the fund commenced on 31 January, 1989. The taxed and untaxed elements of the death benefit are calculated beow in equations.
Based on these components, the tax payable on the death benefit paid to Jessica will be as shown in Table 2.
Death benefit paid directly to beneficiaries vs being paid through the estate
When a superannuation death benefit is paid directly to a non-tax dependant, the super fund trustee is required to withhold the appropriate tax including Medicare levy.
The taxable component of the death benefit received directly by a non-tax dependant is counted towards the individual's assessable income, and therefore taxable income, in the financial year the death benefit payment is received.
While not impacting the marginal rate of tax they will pay on their other income, this can affect their entitlement to receive certain tax offsets and Government concessions. These include the low income tax offset, dependant tax offset, family assistance benefits, spouse contributions tax offset and government co-contribution.
Where a lump sum super death benefit is paid to the estate, no tax is withheld by the super fund trustee. Instead, the executor or administrator of the estate will be required to withhold tax according to the tax status of the ultimate beneficiary or beneficiaries of the lump sum.
Where a death benefit flows from the estate to a tax dependant, no tax will need to be withheld.
Where the benefit flows to a tax non-dependant, the amount is taxed in accordance with the tax rates discussed earlier. Importantly though:
- No Medicare levy is payable when the death benefit is paid from the estate; and
- There is no impact to the beneficiary's other entitlements in the financial year of receipt.
The taxation of the death benefit received through the estate and then paid into a testamentary trust depends on the nature of the trust, for example protective or discretionary, and who the beneficiaries are.
Where the ultimate beneficiary is unknown or it is not clear as to who will benefit, for example the lump sum is paid into a discretionary testamentary trust that has both tax dependent and non-dependent beneficiaries, the whole amount is deemed to have been paid to a tax non-dependant and is taxed accordingly. Once again, in these situations, the payment of any tax liability is the responsibility of the executor or administrator of the estate, and no Medicare levy is payable.
Planning considerations
Clients whose intended beneficiaries include non-tax dependants may wish to consider holding some or all of their life insurance outside of superannuation. This will ensure that non-dependant beneficiaries receive the proceeds tax-free.
Another option to consider may be to gross up the sum insured to take the expected tax liability into account.
If a client intends to set up a testamentary trust in their will to receive superannuation death benefit proceeds, they should discuss with their solicitor whether limiting the beneficiaries of such trusts to tax dependants is appropriate.
This may assist in avoiding some of the adverse tax consequences discussed earlier. In such cases, a separate testamentary trust could then potentially be established using non-super assets to benefit non-tax dependants.
Alena Miles is the technical services manager at AMP TapIn.
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