Background

Currently, to the extent superannuation assets are used to support a pension, income from those assets is exempt from income tax broadly.

TR 2011/D3 suggests that the moment a superannuation pensioner dies, the pension exemption ceases unless the pension is automatically reversionary.

Some recently registered Commonwealth legislation (Income Tax Assessment Amendment (Superannuation Measures No. 1) Regulation 2013) altered this position. It stated that if a pensioner dies without an automatically reversionary pension, the pension exemption will still continue.

The draft of the legislation suggested that it was important to still make pensions automatically reversionary because if not, upon death the interest supporting the pension would mix with any other interests in the fund. However, the finalised version of the legislation addressed and clarified that even if a pension is not automatically reversionary, broadly, the deceased’s pension interest will not mix with any other interests in the fund.

Accordingly, on its face, there is no advantage in having an automatically reversionary pension.

The hidden gem

The new legislation does not say this in as many words. However, the practical implication of it is broadly as follows:

If the fund had a life insurance policy, any pay-out upon death will generally form part of the taxable component.

But what if the deceased was receiving not just a pension, but specifically a pension that was automatically reversionary upon the death of the pensioner? How might that change things? In that situation, the insurance proceeds should take on the tax-free and taxable component proportions of the pension. On the flip side, if the pension is not automatically reversionary, the insurance proceeds will generally form part of the taxable component.

For example, consider Preston. He is receiving a $200,000 pension from his SMSF, funded entirely of the tax free component. The pension is not automatically reversionary. The fund also maintains a life insurance policy in respect of Preston, the premiums are charged against Preston’s pension account. Preston dies. The policy pays out $200,000. The interest is now $400,000 but will generally be comprised of 50 per cent of the taxable component and 50 per cent of the tax-free component.

As a counter example, consider Jennifer. Jennifer’s situation is exactly the same as Preston’s, except Jennifer’s pension is automatically reversionary. When the insurance proceeds are received, they take on the proportions of the pension (ie, in this instance, 100 per cent tax-free component). Accordingly, the person who ‘inherits’ Jennifer’s automatically reversionary pension receives $400,000 of entirely tax-free component.

Is it possible to convert from non-reversionary to automatically reversionary mid-stream?

The question is sometimes posed: if at commencement a pension was not specifically designated as being automatically reversionary, can it be converted to a reversionary pension ‘mid-stream’? The short answer is yes, provided the paperwork is 100 per cent spot on. This was discussed by the Australian Taxation Office at its March 2013 meeting of the National Tax Liaison Group Superannuation Sub Committee.

Conclusion

In spite of the recent law, there can still be a significant benefit in making pensions automatically reversionary.

Bryce Figot is a director at DBA Lawyers.