As with anything superannuation related, there are hidden traps that advisors should be aware of when recommending (or cautioning) clients who are choosing this route.

The first trap is the impact that life insurance held inside superannuation has on the untaxed component of a superannuation death benefit, when paid as a lump sum to a non-death benefits dependant.

Section 307-290 of the Act holds that when the Trustee of a superannuation fund pays a lump sum benefit on the death of a member, and the Trustee has claimed deductions for the life insurance premiums, the untaxed element of the fund is increased by a prescribed formula.

The effect is to essentially increase the amount of the untaxed element of the fund by the value of the insurance proceeds.

The formula in question is as follows:

Where:
• ‘service days’ is defined as the number of days in the ‘service period’ for the lump sum;
• ‘service period’ is defined by reference to the table in section 307-400;
• ‘days to retirement’ is defined as the number of days from the death of the deceased member to the deceased's ‘last retirement day’; and
• ‘last retirement day’ is defined in s 995-1 as the day a taxpayer turns 65, or such other age as determined by their particular employment.

If the recipient of the superannuation death benefit is not a death benefits dependant, the untaxed element of the lump sum benefit is assessable income, with section 302-14(2) providing a tax offset so that the rate of tax is no higher than 30 per cent (plus any relevant Medicare levy). It is important to recall that a non-death benefits dependant may only take a superannuation death benefit as a lump sum.

However, if the recipient of the lump sum is a death benefits dependant, then section 302-60 treats the benefit as non-assessable, non-exempt income in their hands.

As section 307-290 only refers to lump sum benefits, it won’t affect the calculation of the untaxed element of the taxable component if the recipient wishes to or is able to take the benefit as an income stream.

It is not just the untaxed element than may cause an unintended impact when life insurance is paid out as part of a superannuation death benefit. When the deceased and the recipient of a superannuation death benefit are both under age 60, the life insurance forms part of the taxable component. Therefore, if the superannuation death benefit is taken as an income stream, it will be classed as assessable income (being part of the taxable component), with a tax offset equal to 15 per cent per section 302-75. Once the recipient reaches the age of 60, the income stream becomes non-assessable, non-exempt income thanks to section 302-65.

Although it may sound pedestrian, the best way to navigate through the member benefit and superannuation death benefit provisions of the Income Tax Assessment Act 1997 is to set them out in a table format. That way you can appraise yourself of the impact at a glance, with ready reference to the Act itself if need be.

A second caution is to remember that a superannuation death benefit may only be paid to a deceased’s dependant or Legal Personal Representative; requiring strict attention to (a) relationships that underpin your client’s intentions; and (b) the law relating to dependency and de facto relationships as a whole. Where there has been a breakdown in relationships clients must be advised to review their insurances and/or any binding death benefit nominations that seek direct their ultimate payment. Careful attention to estate planning and family law resolution must be recommended in these circumstances.

Of particular note in this area of superannuation death benefits is the application of current ATO commentary to step-children and their classification as dependants (as defined in s 10 of the Superannuation Industry (Supervision) Act 1993). The ATO position in ATO ID 2011/77 holds that on the death of a child’s natural parent, their relationship with a step-parent is ‘severed’, thereby no superannuation death benefit payment can be made from the step-parent to the step-child. This can cause planning difficulties; as the only option remaining for the (surviving) step-parent is to make payments via their Legal Personal Representative. This can have flow-on effects in terms of challenges to the deceased step-parent’s estate.

Currently Queensland Succession Law recognises that the step-parent/step-child relationship is not severed by the death of the natural parent. This may mean the tax law is amended to ‘catch-up’ with the unintended consequences the current position may have on taxpayers.

Unless indicated otherwise, all sections refer to the Income Tax Assessment Act 1997.

David Hughes is a founding partner at Small Myers Hughes Lawyers.