Superannuation Reform: Re-thinking Death Benefit Payments & Reversionary Pensions

Legislation implementing the Government’s Superannuation Reform Package passed through Parliament late last year. Most changes are set to apply from 1 July 2017 and will impact, among other things, the payment of superannuation death benefits and reversionary pensions. Understanding how the changes will affect death benefit payments and reversionary pensions is critical to enabling you to help your client review their death benefit payment plans and/or reversionary pension plans, discuss potential issues and even determine how to restructure such plans to ensure the desired outcome can still be achieved.

This article covers the following areas with practical tips to assist you:

Cashing of superannuation benefits on death
Form of death benefit payments to pension dependants
The new transfer balance cap
Death benefit pensions and the TB Cap
Modifications for reversionary pensions
Roll-over of death benefits
Modifications on TB cap for child dependants
Considering a testamentary trust for death benefits paid out of the superannuation system

1. Cashing of Superannuation Benefits on Death

When a member dies their superannuation benefits (i.e. death benefits) must be ‘cashed’ as soon as practicable after that member’s date of death. ‘Cashed’ includes:

a single lump sum or an interim lump sum and a final lump sum (so that the benefits are paid out of the superannuation system); and
provided the governing rules of a fund permit a pension to be paid, by way of one or more pensions or the purchase of one or more annuities (so that the benefits remain in the superannuation system).

2. Form of Death Benefit Payments to Pension Dependants

Death benefits of a member can only be paid as a pension to a ‘pension dependant’, that is, someone who at the time of the member’s death was:

a spouse of the member;
a child of the member that:

is under age 18
is under age 25 and financially dependent on the member; or
has a disability as defined in subsection 8(1) of the Disability Services Act 1986; or

someone in an interdependency relationship with the member.

Where a child of a deceased member under age 25 receives death benefits as a pension, they must commute such benefits (i.e. paid as a lump sum) on turning age 25 unless they have a disability.

3. The New Transfer Balance Cap

From 1 July 2017 the Transfer Balance (TB) cap will apply to limit the amount of capital individuals can transfer to retirement phase to support pensions. The TB cap will, in turn, limit the amount of super fund earnings that are exempt from tax.

An individual’s TB cap (also known as a transfer balance account) will be $1.6 million for the 2017-18 financial year and will be subject to proportional indexation on an annual basis in $100,000 increments in line with CPI.

The following amounts will be credited to an individual’s TB cap:

the value of all superannuation interests that support pensions in the retirement phase on 30 June 2017;
the commencement value of new pensions (including new death benefit pensions – discussed below) in the retirement phase from 1 July 2017;
the value of reversionary pensions at the time the individual becomes entitled to them (although the time the credit arises is deferred – discussed below); and
excess transfer balance earnings that accrue on excess TB amounts.

Once a pension commences, changes in the value of its supporting interests are not counted as credits or debits to the individual’s TB cap.

If any capital from a pension in retirement phases is commuted as a lump sum (whether it be retained in the accumulation phase within the superannuation system or paid outside the superannuation system to the individual personally), it will give rise to a debit to the individual’s TB cap. A debit will also occur for other specified events that reduce the value of an individual’s retirement phase interests.

If an individual exceeds their TB cap, the Commissioner will direct the individual’s fund to commute/reduce the excess and any associated earnings. The individual will also be liable for excess TB tax on their excess. First-time breaches and all breaches made in the 2017-18 financial year will be taxed at 15%. Second and subsequent breaches occurring in the 2018-19 and later financial years after will be taxed at 30%.

4. Death Benefit Pensions and the TB Cap

The value of a death benefit pension paid to a dependant will be credited to the dependant’s TB cap and will include investment gains accrued to the deceased member’s superannuation interest between the time the deceased died and the death benefit pension became payable to the beneficiary.

A death benefit beneficiary must therefore manage their affairs to ensure that a death benefit pension does not result in them exceeding their TB cap. If a death benefit pension in combination with the beneficiary’s own pension results in the beneficiary exceeding their TB cap, they must decide which pension to commute.

A death benefit cannot be held in an accumulation interest as this contravenes the requirement to cash the benefit out of the system as soon as practicable (regulations will soon be introduced to require pensions to be held in retirement phase to ensure that any death benefit pension paid to a dependant must be within their TB cap).

TIP: A death benefit beneficiary could choose to receive a death benefit pension and commute their own pension from the retirement phase to the accumulation phase. This would minimise the amount that must be paid to the beneficiary as a death benefit lump sum outside of the super system and cap the tax on earnings generated from such benefits to 15% in the fund rather than their marginal tax rate outside of the fund).

5. Modifications for Reversionary Pensions

Reversionary pensions are different to other death benefit pensions because they revert to the beneficiary immediately on the death of the member (rather than at the discretion of the fund’s trustee). That is, the next pension benefit payment (whenever that may be) is payable to the beneficiary.

The resulting credit in the beneficiary’s TB cap is the value of the pension at the time it becomes payable to the beneficiary and does not include investment gains accrued between the death of the pensioner and the pension becoming payable to the beneficiary. However, a modification applies to defer the time the credit arises in the beneficiaries TB cap to 12 months after the pension benefit first becomes payable to the beneficiary – thereby giving the beneficiary sufficient time to adjust their affairs before any consequences arise (e.g. breaching their TB cap).

This deferral also applies to individuals already receiving a reversionary pension on 30 June 2017. Specifically, the credit for this arises on the later of 1 July 2017 (where the pension benefits became payable before 1 July 2016) or 12 months after the pension benefits became payable to that beneficiary.

TIP: Subject to the impact caused on any Government benefits your client may be receiving (including a Commonwealth Seniors Health Card), it may be preferable for your client’s current pension to be restructured as reversionary pension so that the beneficiary who will receive the pension benefits on the member’s death will have 12 months to order their affairs before that pension is credited to the beneficiary’s TB cap.

6. Roll-Over of Death Benefits

The new laws will allow the beneficiary of a death benefit pension to choose the super fund from which their pension will be paid (by enabling the beneficiary to roll-over the death benefit to such fund without having it treated as a contribution).

7. Modifications on TB Cap for Child Dependants

The TB cap for child dependants receiving a death benefit pension from a deceased parent is subject to modification to allow the child to receive their share of the deceased parent’s retirement phase interest without prejudice to the child’s future retirement. That is, the child’s cap will be set by reference to their portion of the deceased parent’s retirement phase interests rather than the general TB cap. The child’s TB cap will generally extinguish when they reach age 25 and are required to cash out the death benefit pension or earlier than this if the capital is exhausted. This ensures that the child does not exhaust their TB cap before they retire. Specifically:

For death benefit pensions that commenced before 1 July 2017, the child’s TB cap is $1.6 million; and
For death benefit pensions that commence from 1 July 2017:

Where the deceased parent did not have a TB cap, the child’s TB cap is:

If the child is the sole beneficiary of the deceased parent’s superannuation interests – the general TB cap; or
If the child is not the sole beneficiary of the deceased parent’s superannuation interests – the child’s proportionate share of the parent’s interests multiplied by the general TB cap;

Where the deceased parent does have a TB cap, the child’s TB cap is their portion of the parent’s interest that were in the retirement phase that the child received as a pension. For a reversionary pension, the child’s TB cap is deferred for 12 months. To be within the child’s TB cap, the death benefit pension the child receives must be sourced solely from the retirement phase of the deceased parent (amounts outside of the retirement phase will generally result in the child having an excess TB with associated tax payable). Similarly, if the child’s death benefit pension is only partly sourced from the deceased parent’s retirement phase interests the amount of the child’s TB cap will equal only this part (amounts sourced from the accumulation phase interest will generally exceed the child’s TB cap). Generally, an amount is sourced from the deceased parent’s retirement phase interest if it can be shown that the amount came from superannuation interests that supported superannuation pensions payable to the parent just before their death (i.e. their retirement phase interest).

TIP: If a parent dies with both an accumulation phase interest and a pension phase interest, consider paying the pension phase interest to the child as a pension and the accumulation phase interest to the spouse as a pension.

Where the deceased parent had an excess TB, the child’s TB cap is reduced if their deceased parent had an excess TB just before their death. The child’s cap is reduced by their proportionate share of their parent’s excess TB. However, their cap is not reduced to the extent that the child receives their entitlement to the deceased’s retirement phase interest as a death benefit lump sum (instead of a pension).
Where both parents die, the child’s TB cap is the sum of amounts worked out in relation to each parent.

Additionally, there may be some rare circumstances where a child has a TB cap before they start to receive a death benefit pension as a child recipient. In these circumstances, the child’s TB cap is increased by the sum of the cap increments discussed above.

Once a child recipient’s TB cap ceases (because, for example, they turn age 25 or the capital is exhausted), their entire position with respect to TB cap is generally reset. When the child subsequently retires, they can start a new TB cap based on the general TB cap at that time.

8. Considering a Testamentary Trust for Death Benefits Paid Out of the Superannuation System

Given that death benefit payments exceeding the TB cap or modified TB cap for children (excess death benefits) must be paid out of the superannuation system, advisers and their clients may wish to consider the financial outcomes and practical and legal risks of paying such excess death benefits (or any death benefits, for that matter) into a testamentary trust.

To estimate the financial benefits of paying excess death benefits into a testamentary trust one of the first matters that needs to be determined is whether the beneficiaries of the testamentary trust are limited to death benefit dependants. If they are, then the benefits will be paid tax-free. If they are not, then death benefits tax will most likely apply but without the imposition of the Medicare levy.
Once the excess death benefits are invested, the testamentary trust structure can permit income to be distributed to minors as excepted trust income with the minors taxed as adults (i.e. approximately $20,000 can be paid tax free to each minor). Perhaps most usefully, if the testamentary trust is a ‘discretionary trust’, different amounts of income can be allocated to different beneficiaries which may optimize the after-tax returns to the family group and give flexibility depending on the needs and circumstances of the beneficiaries. However, payment of excess death benefits to a testamentary trust that includes beneficiaries who are non-death benefit dependents will result in the death benefits tax applying, even if some or the ‘principal’ beneficiaries of the trust are death benefit dependents.
If excess death benefits are paid into an estate they become part of the ‘pool’ of assets which may be subject to a family provision claim. This is one potential shortcoming of paying superannuation into an estate which could concern clients (particularly in a blended family situation) and the better option may therefore be paying excess death benefits to the beneficiary personally.
The transfer of excess death benefits to a testamentary trust can offer asset protection. It will generally preclude a beneficiary from becoming the ‘owner’ of the assets. As such, if the beneficiary is being pursued by creditors then those creditors may not be able to access the assets. Additionally, where a beneficiary is under a disability or has a problem such as gambling, drug dependency, etc. a testamentary trust controlled by an independent trustee can protect assets from being misused and at the same time look after the beneficiary’s long term interests (as well as the interests of others such as the beneficiary’s children).

TIP: Existing death benefit nominations and reversionary pensions should be reviewed and potentially amended to enable amounts exceeding a beneficiary’s TB cap to be paid to the deceased’s legal personal representative (i.e. the estate) and then into a discretionary testamentary trust for the primary benefit of the dependant beneficiary.

Please contact Thalia Dardamanis or Bernie O’Sullivan if you would like assistance in reviewing, discussion and/or amending your clients’ death benefit nominations and reversionary pensions in light of the superannuation reform.