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Re-contributions another victim of Budget


Re-contribution strategies are widely-used to minimise the impact of the so-called ‘death tax’ on death benefit lump sums paid to adult children of deceased superannuation members. Unfortunately, it could be a casualty of the proposed new rules for non-concessional contributions contained in the Federal Budget.

 

Re-contribution strategies are widely-used to minimise the impact of the so-called ‘death tax’ on death benefit lump sums paid to adult children of deceased superannuation members. Unfortunately, it could be a casualty of the proposed new rules for non-concessional contributions contained in the Federal Budget.

Whether or not the Government intended to deliberately affect those who implemented this strategy by restricting their future access to non-concessional contributions, this would be the result if those proposed changes became law.

The proposal to limit the non-concessional contribution cap to a lifetime $500,000 can be seen for what it is – a need to shut down people contributing millions of after-tax dollars into the tax-effective superannuation environment.

So what is the context of this re-contribution strategy, how has it been used in the past and how do the proposed changes impact those who have adopted it?

The core purpose of superannuation

A core purpose of superannuation is to provide benefits to members in their retirement. These benefits when received are either not taxed at all if the recipient is 60 or over, or very concessionally taxed if under 60.

Notwithstanding this core purpose and while they are alive, members can also choose not to take any sort of benefit from their super arrangement and leave their account balance in accumulation phase indefinitely.

Payments on death of a member

Another core purpose is the payment of benefits on the death of a member to their legal personal representative or dependants. Unlike when a member is alive, however, regulations require the death benefit be paid as soon as possible after death.

The taxation of the benefit, which must be paid in these circumstances, will depend on who the death benefit is paid to, and the type of death benefit allowable depends on who the recipient is:

a) Payments to death benefit dependants

Lump-sum death benefits paid to a surviving spouse, child under 18, someone in an interdependent relationship or financially dependent on the deceased, are tax-free. Death benefit pensions are also payable to these dependants and are either tax free or concessionally taxed.

b) Death benefits paid to other dependants such as adult children

For adult children of the deceased, the options are more limited in terms of benefits payable and the taxation of those benefits. Only death benefit lump sums can be paid to these individuals under superannuation and tax rules. Pensions cannot be paid to adult children of the deceased member, except in limited circumstances and only for limited periods of time.

This is mainly to prevent successive generations passing on entitlements to pensions to the next generation, regardless of their age or retirement status. In this scenario, if allowed, adult children of the deceased would receive a tax effective or even tax-free pension prior to their normal retirement age, and the underlying investment income derived from the assets supporting the pension would be tax free within their fund.

The legislative response

By only allowing adult children to receive a lump sum death benefit, the deceased member’s account balance is forced out of the superannuation system, short-circuiting the pension in perpetuity strategy. The only way for this money to find its way back into the super system is by way of a contribution by the adult children. These contributions are limited by caps and access to account balances is also limited until a later condition of release has been met. There are, however, consequences in limiting the benefits payable to adult children.

The death tax

Death benefit lump sums paid to adult children are subject to a flat tax rate of 15% plus the Medicare levy on the taxable component of the lump sum. All attempts to lobby successive governments to change this tax treatment, often dubbed the ‘hidden superannuation death tax’, have failed, to the point that it is not generally accepted as an item for discussion at all.

So if politicians and bureaucrats won’t talk about it, how can advisers, whether they are accountants, financial planners, lawyers or administrators, help to mitigate the impact of this tax?

Strategy from advisers to increase the tax-free component

The most common response to date has been to reduce the taxable component of the death benefit lump sum (the amount subject to tax at 15% plus the Medicare levy).

For many years, both before and after the change in the calculation of the components of superannuation entitlements from 1 July 2007, common strategies have included:,

a) re-contribution, which involves cashing out superannuation entitlements from unrestricted non-preserved components, paying any tax applicable, if at all, then using these proceeds to make a non-concessional contribution back into the super arrangement, or

b) simply making large non-concessional contributions from sources outside superannuation into the member’s super account.

Both strategies have successfully increased the tax-free component of the contributing member’s account balance and reduced the taxable part. Hence, the impact of the tax on death benefit lump sums paid to adult children has been minimised. The strategies were accepted by the ATO as legitimate for tax planning.

This was done in good faith by members of all types of super arrangements in an environment where non-concessional contribution caps were initially set at $150,000 per year with the ability to contribute up to three years’ worth ($450,000) at any time in a three-year period. More recently, this was increased to $180,000 per year or $540,000 in a three-year period.

The new problem

The consequences of the Government’s decision to count non-concessional contributions made as part of the re-contribution strategy described in example (a) above from 1 July 2007 against the new lifetime cap, appears to have not been considered.

These non-concessional contributions have not been funded from large non-superannuation resources, but from existing saved super entitlements, which have been recycled to improve the tax consequences of certain death benefits. They have not substantially increased the account balances of the members who have undertaken these strategies. In fact, the account balances in some instances have been reduced by the lump sum tax paid on the benefits withdrawn before being re-contributed.

Unintended or not?

It is not possible to know whether this was an intended consequence of the Budget announcements or not. Discussions have centred around large non-concessional contributions made prior to Budget night that have substantially increased member account balances.

If nothing else, it highlights the complexity of amending superannuation legislation in Australia, where a change in policy and subsequent amendment of relevant legislation can have a wider-than-expected impact on the actions of people acting appropriately and legally when saving for their retirement.

It also draws into question the ongoing use of the re-contribution strategy as a means of minimising the impact of the tax on death benefit lumps sums paid to adult children of deceased members. It may even provide an unexpected windfall in tax collected on death benefit payments made in these circumstances.

About the author
Peter Hogan is Head of Technical, SMSF Association.
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