Tax on super death benefits: Paid to estate v beneficiary

Two options are available when paying a lump sum superannuation death benefit to a SIS dependant who is a non-tax dependant, such as an adult child. The sum death benefit can be paid directly from the deceased member’s super fund to the beneficiary, or it can be paid to the deceased’s estate and then distributed to the beneficiary.

In both cases, the tax-free component can be received tax-free while the taxable taxed element is subject to a maximum 15 per cent tax and the taxable untaxed element to a maximum 30 per cent tax.

However, whether the lump sum death benefit is paid directly or through the estate can result in different financial outcomes for a non-tax dependant. As an example, this article uses the situation of a deceased member’s adult child who is a SIS dependant but not a tax dependant to compare the different tax treatments and other flow-on effects.

WHO IS A DEPENDANT?

The definition of a dependant for super law purposes (ie Superannuation Industry (Supervision) Act (SIS) dependant) determines whom the super fund can pay the deceased member’s death benefit to, while for tax purposes (ie tax dependant) determines whether the taxable component of the lump sum death benefit is subject to tax. The starting point is to understand a beneficiary’s dependency status.

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SIS dependants

The trustee can generally only pay a super death benefit directly to:

• the deceased member’s legal personal representative (ie deceased estate), and/or
• one or more of the deceased member’s SIS dependants, being the deceased’s spouse or de facto spouse, a child of the deceased (any age), a financial dependant of the deceased or a person who was in an interdependency relationship with the deceased.

Where a member wishes for their death benefit to be paid to an adult child, the member can either nominate their adult child as a beneficiary to receive the death benefit directly from the fund, or direct their death benefit be paid to their deceased estate, and then to the child as a beneficiary through their Will.

If an intended beneficiary is not a SIS dependant, the death benefit can be directed to the deceased estate (by making a binding or non-lapsing nomination to the legal personal representative). The deceased’s Will can then instruct the executor of the deceased estate to pay a death benefit to this beneficiary from the estate.

Tax dependants

A lump sum death benefit can be paid to a tax dependant tax-free regardless of whether the death benefit contains any taxable component. In contrast, the taxable component of a lump sum death benefit is subject to tax (see below 'Tax on lump sum super death benefits' for details) when paid to a non-tax dependant.

A tax dependant can include the deceased’s spouse, de facto spouse or former spouse, a child of the deceased under 18 years old, a financial dependant of the deceased, a person who was in an interdependency relationship with the deceased, or a person who receives a super lump sum because the deceased died in the line of duty regardless of their relationship to the deceased.

A financially independent adult child is generally regarded as a non-tax dependant, even if the adult child and the deceased parent were living together.

Tax on lump sum super death benefits

The trustee of a super fund needs to calculate the tax-free and taxable component when a lump sum death benefit is paid. The taxable component can be the taxed element, being the element the fund has paid tax on, or the untaxed element. The latter can occur if:

• The death benefit is paid from an untaxed super fund where a fund has not paid any tax on the contributions or earnings; or
• The lump sum death benefit contains an insurance payout and the fund claimed a tax deduction for the insurance premium where the member died under age 65. If the deceased member was 65 or over at the time of death, the untaxed element would be reduced to $0.

The rate of tax that will apply to the taxable component of a lump sum death benefit depends on the recipient’s tax dependency status and the amount of each element that forms part of the taxable component, as shown in table one. Note that the Medicare Levy is payable where the lump sum death benefit is paid directly to a beneficiary, but isn’t payable via deceased estate.

Lump sum tax offset and maximum tax rate

Where a lump sum death benefit is paid to a non-tax dependant, the taxable component (both taxed and untaxed elements) forms part of the taxpayer's assessable income. However, the taxpayer receives a lump sum tax offset, calculated by the Australian Taxation Office (ATO) and based on the tax return information, to ensure the tax payable does not exceed the specified maximum rates of tax.

When a lump sum death benefit is paid to a non-tax dependant (directly or via the deceased estate):

• if the taxpayer’s marginal tax rate exceeds the specified tax rate, the ATO will apply the lump sum tax offset to ensure that the taxpayer does not pay more than 15 per cent tax on the taxable taxed element and 30 per cent on the taxable untaxed element; or
• if the taxpayer’s marginal tax rate is lower than the specified maximum tax rate, the taxable component of the lump sum death benefit is subject to the marginal tax rate.

Who is the taxpayer depends on whether the death benefit is paid direct to the non-tax dependant from the deceased’s super or via the deceased estate. Please refer to 'Who is liable to pay tax on lump sum death benefits' section below for details. 

Order of including income subject to different tax rates

Where a taxpayer has ordinary taxable income subject to their marginal tax rate and also receives a lump sum death benefit containing both taxed and untaxed elements subject to maximum tax rates, it is our understanding that the tax practice is to apply these steps to calculate the lump sum tax offset: 

STEP 1 Include the taxpayer’s ordinary taxable income subject to marginal tax rate.

STEP 2 Add amounts taxed at a higher maximum tax rate, such as the taxable untaxed element of the lump sum death benefit that is subject to 30 per cent maximum tax rate.

STEP 3 Add amounts taxed at a lower maximum tax rate, such as the taxed element of the lump sum death benefit that is subject to 15 per cent maximum tax rate. 

WHO IS LIABLE TO PAY TAX ON LUMP SUM DEATH BENEFITS?

Depending on whether a non-tax dependant, such as an adult child, receives the lump sum death benefit directly from the deceased’s super fund or from the deceased estate, the tax outcome can be surprisingly different for the beneficiary. 

Payment made directly from super fund

A lump sum death benefit can be paid to a non-tax dependant beneficiary directly from the super fund if the beneficiary is a SIS dependant. This may be the case if the deceased made a binding or non-lapsing nomination to this beneficiary, or the trustee of the fund exercises discretion to pay the death benefit to this beneficiary.

The trustee of the super fund must withhold tax on the taxable component of the lump sum as shown in table two.

The non-tax dependant beneficiary then needs to declare the taxable taxed and untaxed elements in their tax return as assessable income. The amount withheld by the super fund becomes a tax credit to reduce the individual’s tax liability and can be refunded to the beneficiary if in excess.

The inclusion of the taxable taxed and untaxed element in the individual beneficiary’s tax return means the beneficiary will have higher assessable and taxable income in the financial year that the lump sum death benefit is received, which can have flow-on effects such as:

• the Medicare Levy can apply to the increased taxable income;
• the Medicare Levy surcharge can apply where the beneficiary does not have private hospital insurance;
• reduction or elimination of the low-income tax offset, low income and middle income tax offset and seniors and pensioners tax offset;
• impact on Government co-contribution and spouse contribution tax offset;
• Division 293 tax;
• reduction or elimination of Family Tax Benefit payments; and
• increase in child care cost due to the potential reduction in Child Care Subsidy.

Death benefit paid to non-tax dependant via deceased estate

The trustee of a super fund can pay the deceased member’s death benefit to the deceased estate where:

• the deceased member made a binding or non-lapsing nomination to their legal personal representative; or
• a binding nomination was not made and the fund’s default provisions require payment to the estate; or
• the trustee exercised discretion to do so.

The super fund will pay the entire death benefit as a lump sum to the deceased estate as it is not subject to PAYG withholding tax. It is then the responsibility of the deceased’s legal personal representative (ie executor of a will or the administrator in the case of intestacy) to pay tax on the taxable component of the lump sum when it is paid to a non-tax dependant from the estate.

The executor or administrator must include the taxable taxed and untaxed elements in the deceased estate’s trust return as assessable income when these amounts are paid to a non-tax dependant. The same maximum tax rate and ordering rules mentioned in earlier sections apply. However, for tax law purposes the benefit is taken to be income in the trust to which no beneficiary is presently entitled, which means Medicare Levy is not payable when the death benefit is paid from the deceased estate to a non-tax dependant.

The executor or the administrator must deduct tax from the taxable component of the lump sum before paying the death benefit to a non-tax dependant beneficiary. The beneficiary does not need to declare this income in their tax return, hence no increase in their assessable and taxable income.

Example

Phoebe (age 40) is a single parent with two young children under age five. Phoebe earns $40,000 per year from a part-time job. She is receiving full Family Tax Benefit Part A and Part B totalling around $15,000 per year.

Phoebe’s mum Doris recently passed away. Phoebe is the sole beneficiary of her estate and the executor of her Will. Doris’ estate has very little income generating assets. The estimated annual income in her deceased estate is around $5,000.

Doris was 63 at the time of death, and her super death benefit contains a death cover payout. The trustee of Doris’ super fund calculated the tax components of her lump sum death benefit as in table three.

Doris didn’t bother making a death benefit nomination as in her mind everything would go to Phoebe anyway. Subject to the super fund’s governing rules, Phoebe potentially has two options:

1. request the super fund to pay Doris’ death benefit to her directly; or
2. request the super fund to pay Doris’ death benefit to her deceased estate and receive the lump sum through the estate. 

Phoebe is a non-tax dependant. With either option:

• $100,000 tax-free component can be received tax-free and will not form part of the taxpayer’s assessable income;
• $150,000 untaxed element forms part of the taxpayer’s assessable income but taxed at a maximum 30 per cent. This amount is regarded to have been received first before the taxed element; and
• $200,000 taxed element forms part of the taxpayer’s assessable income but taxed at a maximum 15 per cent. This amount is regarded to have been received later than the untaxed element.

Table four compares the amount of tax payable under the two options. With option one, Phoebe is the taxpayer. She needs to include the taxed and untaxed elements in her tax return which will increase her taxable income from $40,000 to $390,000 in the year the lump sum death benefit is paid. This means:

• Phoebe needs to pay Medicare Levy on the entire $390,000 taxable income, including the taxable component of the lump sum death benefit payment;
• Phoebe will lose the $15,000 Family Tax Benefit payments;
• Phoebe cannot benefit from the low-income tax offset and the low income and middle-income tax offset;
• Phoebe’s child care costs will most likely increase due to the reduction in her child care subsidy payment because of higher income level;
• Phoebe will be subject to Division 293 tax on her concessional contributions, given her income exceeds the $250,000 threshold; and
• If Phoebe were to make a non-concessional contribution, she would not be able to receive the Government co-contribution due to the increased income level.

With option two, the taxpayer is the deceased estate (ie the executor pays tax on behalf of the estate) when the lump sum is paid from the estate to a non-tax dependant of the deceased. This means:

• Medicare Levy is not payable. For tax law purposes the taxable component of a lump sum benefit is taken to be income in the trust (ie deceased estate) to which no beneficiary is presently entitled, which means Medicare Levy is not payable when the death benefit is paid from the deceased estate to a non-tax dependant;
• When Phoebe receives a net of tax distribution from Doris’ deceased estate, she does not need to report this income in her tax return. As a result, her taxable income will remain unchanged at $40,000. The flow-on effects due to the increase in her income level mentioned in option one won’t apply here; and
• Doris’ deceased estate only has $5,000 of other income. This means the remaining $13,200 tax-free threshold can apply to the untaxed element and 19 per cent tax rate (rather than 30 per cent) applies to part of the untaxed element that does not take trust income to the next tax bracket. 

Linda Bruce is senior technical manager at FirstTech.