A guide to superannuation death benefit strategies

Jennifer Brookhouse outlines the issues to consider when deciding whether a superannuation death benefit going to a child should be paid as an income stream or into a testamentary trust.

A superannuation death benefit can be paid as an income stream to a dependant (as defined in the Superannuation Industry (Supervision) Act). A child of the deceased fund member meets this definition if, at the time of the member’s death, the child is:

• Less than 18 years of age
• Aged 18 to 25 and financially dependant upon the member, or
• Aged 18 or older and a disabled child

The income stream paid to the child (excluding a disabled child) can only be paid until the child reaches age 25. At age 25, the income stream must be commuted and any remaining capital is paid as a tax-free lump sum. An income stream payable to a disabled child can continue to be paid regardless of age.

An account-based pension (ABP) or other superannuation income stream paid to a child can be either:

• A continuation of a superannuation income stream which was being paid to a member before their death (ie, reversionary), or
• Commenced from superannuation held in the accumulation phase.

In order for a pension to be paid from benefits held in the accumulation phase, the superannuation fund must be able to pay an income stream.

Some providers allow a binding death benefit nomination to specify both the beneficiary and the form of the benefit. This provides the client with control over how the benefit will be paid.

Clients should keep the nomination up-to-date. The trustee only confirms the nomination’s validity at the time of the client’s death.

If there is no binding nomination and the trustee indicates the child will be paid a lump sum, it is worthwhile writing and requesting the death benefit be paid as an income stream. In some cases the trustee will only pay a lump sum.

However, this could only happen by making sure that all possible options have been considered.

Establishing a testamentary trust

A testamentary trust is established from instructions in a client’s will. It is important to have a solicitor correctly draft the will to ensure the testamentary trust achieves the client’s goals and objectives.

In some cases, the will may be drafted to give the executor the option of creating a testamentary trust rather than making it compulsory.

A death benefit paid from superannuation to a tax dependant is tax-free. A superannuation death benefit must be first paid to the deceased’s estate before being directed to the testamentary trust.

The taxation of the superannuation death benefit when received by the testamentary trust depends on who the underlying beneficiaries are.

If all beneficiaries are tax dependants, the amount is received by the trust tax-free. If any of the beneficiaries are non-tax dependants, the total amount of the superannuation death benefit is treated as if received by a non-financial dependant.

Care needs to be taken to ensure the testamentary trust beneficiaries are tax dependants. Consideration may be given to having more than one testamentary trust or limiting the beneficiaries of the testamentary trust receiving the superannuation death benefit to ensure the amount is tax-free.

Strategy considerations

Taxation of income

When comparing testamentary trusts and child ABPs, one aspect to consider is the taxation of income received, which is summarised below.

Child ABPs

The taxation of the income paid from an ABP to a child will depend on the original owner’s age as the child will be under age 25.

Income from an ABP is also eligible for the Low Income Tax Offset (LITO) of up to $1,500.

Testamentary trust 

Income distributed from a testamentary trust to a child under 18 is taxed at adult marginal rates. This income is also eligible to receive the LITO of up to $1,500. The penalty tax rates applying to unearned income do not apply to distributions from testamentary trusts.

Testamentary trusts are usually discretionary. This gives the trustee discretion to decide which beneficiaries receive income or capital and the timing.

This also allows the trustee to direct income or capital in a tax-effective manner. Generally, a trust will distribute all income to beneficiaries.

Any income not distributed will be taxed in the hands of the trustee at 45 per cent. Income received by the beneficiary is taxed at ordinary marginal rates and the Medicare Levy and Flood Levy may be payable.

Comparison of taxation

In the example provided in Table 2, although the income from the testamentary trust has a tax liability, other factors (eg, control and asset protection) may outweigh the additional tax liability. 

Also, the additional tax may be only a short-term implication, as the income stream paid to the child must be commuted by age 25 unless they are disabled. If not, the capital is paid to the child and any earnings are taxed at the child’s marginal rate.

Anti-detriment payments

An anti-detriment payment may be added to a death benefit paid as a lump sum to the child (including via the estate to a testamentary trust). The lump sum may be paid from the accumulation phase or the commutation of a pension. 

While the anti-detriment payment increases the lump sum payable, it is not payable if the death benefit is paid as an income stream. Only lump sum death benefit payments will attract an anti-detriment payment.

Death benefits received as a lump sum must be received in cash and leave the superannuation environment.

Note that the anti-detriment is a voluntary payment. Not all superannuation funds will pay an anti-detriment payment and some funds, such as self-managed superannuation funds (SMSFs), may not be able to make the payment.

Control

A key question to ask clients is ‘when do you want the child to have control of the funds?’ While a child is under age 18, a Power of Attorney can assist with the management of an ABP. A child will have control of funds held in an ABP from age 18. 

The child can decide to commute the pension to a lump sum at any time from 18. This may not be the ideal time for the child to have access to the capital.

If commuted, all remaining capital is received. Partial commutations are not permitted for death benefit income streams to a child.

The rules of a testamentary trust may specify that capital cannot be distributed to a child until a particular age, such as 21, 25 or older. The rules may leave it to the trustee’s discretion to determine when capital is payable.

This discretion would enable a trustee to consider the child’s circumstances before paying out the capital, rather than relying only on the child turning a particular age.

Asset protection upon relationship breakdown

A testamentary trust allows the asset to remain within the family bloodline. For example, a future spouse of a child would not be a trust beneficiary. 

The assets in the testamentary trust may be considered a financial resource for the division of assets upon a relationship breakdown. The asset of the trust will not form part of the assets of the relationship (unless the child is the sole beneficiary) and cannot be divided as part of a property settlement.

The capital in an ABP must be paid by age 25. This becomes capital in the child’s name and may form part of the relationship assets. This exposes this amount to being divided if the relationship breaks down.

Asset protection upon bankruptcy

While the possibility of bankruptcy may be an important consideration, it may be difficult to measure when the beneficiary is a child. Normally, consideration would be given if the beneficiary was in a high-risk profession (eg, company director, doctor or small business owner).

Assets held in a testamentary trust are protected from potential creditors (unless the child is the sole beneficiary). If using a testamentary trust for bankruptcy protection, ensure the trustee has discretion on the distributions of income and capital.

Also ensure there are other beneficiaries of the trust (who are also tax dependants at the time the trust is established) to ensure the superannuation benefit is received tax-free and an anti-detriment payment is made.

The level of protection from bankruptcy is not clear in relation to superannuation income streams. Income received from an ABP may be available to repay creditors. The lump sum the child may receive (either by voluntary or compulsory commutation) is not accessible only if the lump sum is received after bankruptcy.

Beneficiaries with special needs

A child may have special needs which may warrant access to capital to be restricted beyond age 18. In this case, a testamentary trust would be a more appropriate option.

Examples of special need beneficiaries include those who are spendthrift or have a gambling, alcohol or drug addiction. Capital in an ABP is accessible from age 18, as this is when the child has legal control over the account.

Cost and trusteeship

The cost and benefits of the strategy must be considered. The cost of the ABP may include the management fees charged by the retail superannuation fund. SMSFs will have other fees.

For SMSFs, consideration should be given to who will be the child’s legal personal representative (LPR) while under age 18. The LPR will act as the trustee on behalf of the child and participate in the running and decision-making of the SMSF. 

Ensure the trustee is someone who understands the client’s wishes. As trustee of the superannuation fund, the client wants to ensure that the SMSF will continue to operate efficiently; for example, that trustees are able to reach agreement on issues.

A testamentary trust is a legal structure and will need to satisfy certain requirements, such as completing annual tax returns. The trustee may need to seek professional advice (eg legal, accounting, financial planning), and the costs paid by the trust should be compared to the strategy benefits.

Clients should also carefully consider who is nominated as the trustee and appointer of the testamentary trust. The trustee will be responsible for managing the money until payable to the child.

The trustee needs to understand what the client is hoping to achieve, and details should be provided in the will or deed of wishes. 

The appointer is able to remove the trustee and replace that person with another person. Again, carefully consider who this person will be and their understanding of the client’s objectives.

Conclusion

When estate plans are being made and children are potential beneficiaries, it’s important to weigh up the advantages and disadvantages of child ABPs and testamentary trusts and consider the ‘what ifs’.

Jennifer Brookhouse is a senior technical consultant with MLC Technical Services.