Accurium recently confirmed with the ATO that there is another benefit to automatically reversionary income streams which SMSF professionals should be aware of.

Life insurance proceeds received by an SMSF

If a member holds a life insurance policy in their SMSF then upon their death the SMSF will receive the proceeds of that policy. The payout will be treated differently under the TBC depending on whether the member’s income stream was reversionary or not.

Law Companion Ruling 2017/3 deals with life insurance and non-reversionary income streams. The commencement value of a death benefit income stream includes any investment earnings accrued to that point. This includes any proceeds from a life insurance policy if it is decided that this will be paid as a death benefit income stream — regardless of whether the policy was held in respect of an accumulation or retirement phase interest of the deceased member.

This means that where a pensioner passes away with no reversionary income stream, the value of any life insurance payout would be included in the commencement value of a resulting death benefit income stream. The death benefit recipient would have a credit applied against their TBC equal to the balance of the death benefit pension at date it commenced inclusive of the insurance proceeds.

However, with an automatically reversionary income stream the TBA credit value is the account balance on the 'starting day', meaning the date the pensioner passes away. Given that any life insurance proceeds will not be received until after this date, they would not form part of the account balance, and therefore the credit value for TBC purposes. This means that for an automatically reversionary income stream that included a life insurance policy (and where proceeds would be paid into this interest after death) then the value of the payout would not raise a TBA credit. A credit equal to the balance of the automatically reversionary income stream at date of death would apply to their TBA twelve months later. The life insurance proceeds, not matter how large, would not impact the TBC and could remain in the tax free retirement phase.

Case study - TBC implications of life insurance proceeds

Life insurance policies can often provide a significant monetary payout on death. If the retiree establishes their income stream as an automatically reversionary income stream, this could provide a significant benefit in terms of the amount that their spouse can retain in tax free retirement phase upon their death.

Consider a two member SMSF, husband and wife Brad and Angelina, each with $700,000 in accumulation phase and looking to retire. Brad has a life insurance policy in the SMSF with a $500,000 sum insured.

Unfortunately Brad is involved in an accident and passes away suddenly two years later. The balance of both of their income streams at this time is $600,000.

The life insurance payout of $500,000 is received by the fund following Brad’s death. Angelina wants to take the death benefits as an income stream in the SMSF.

Option 1

Let’s first assume Brad and Angelina had commenced a non-reversionary account-based income stream with their $700,000 account balance. This applies a credit of $700,000 to their TBA and they each have a remaining TBC of $900,000.

After Brad’s death his account-based pension and life insurance proceeds paid as a death benefit income stream would create a transfer balance credit of $1,100,000 to Angelina’s account at that time. Her remaining TBC at this time is only $900,000 and taking this action would create a $200,000 excess transfer balance.

Angelina could take action upon Brad’s death and commute an amount of $200,000 from her existing income stream to accumulation phase; this would create a debit against her TBA and increase her remaining TBC to $1,100,000 allowing her to accept the entire death benefit pension.

Alternatively she could take the death benefit as $900,000 in a death benefit income stream and $200,000 as a lump sum death benefit.

Either of these options creates an asset for Angelina that may produce taxable income, as all assets are no longer in the tax free retirement phase.

Option 2

Let’s instead assume that Brad and Angelina commenced automatically reversionary account-based income streams with their $700,000 balance, with the pensions reverting to each other should they pass away.

Upon Brad’s death Angelina would become entitled to Brad’s reversionary income stream. The balance at date of death of $600,000 would apply as a credit to her TBA in twelve months’ time. When the insurance proceeds are received shortly after death into the pension interest this is treated like earnings and does not raise an additional transfer balance credit. With a remaining TBC of $900,000 Angelina can accept this reversionary income stream, in twelve months’ time the credit will reduce her remaining TBC to $300,000. She retains the entire SMSF balance of $1,700,000 in the tax free retirement phase, $600,000 in her existing account-based income stream, and $1,100,000 in the reversionary income stream.

* In 12 months’ time

 Conclusion

For SMSF clients holding life insurance policies in their funds, it is worth considering how any payout would impact their beneficiaries’ TBC. Automatically reversionary income streams may help ensure the proceeds are not counted towards the cap. 

By Melanie Dunn, actuary and technical services manager, Accurium