Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 244

When death benefits include life insurance

Death benefits that include life insurance proceeds require an understanding of how to manage the tax consequences. The amount of tax levied on such a payment from a superannuation fund depends on whether a member has any ‘tax dependants’, their ‘eligible service date’ (ESD) and whether the member died before reaching age 65. Trustees should have these details available if a death or disability benefit becomes payable.

Let’s see how tax is impacted by these factors by focusing on life insurance which can be worthwhile to have inside an SMSF for two main reasons:

  1. The premium can be tax deductible to the fund (provided the fund complies with the relevant requirements) but not when paid by individuals.
  2. The insurance premium is not funded from personal cash flow but from deductible contributions or the fund’s investment income.

The rules governing premiums and proceeds

Outside super

Life insurance premiums paid on policies held outside superannuation are not eligible for income tax deductions. However, the proceeds from life policies attract no income tax upon death or many other insured events.

Inside super

Likewise, insurance proceeds paid by the insurer to an SMSF are not taxed in the fund. However, any resulting benefits paid by the fund because of the death of a member are tax free if paid to a ‘tax dependant’ as a lump sum.

If the lump sum is paid to a ‘non-tax dependant’ the ‘taxable component’ of the lump sum is taxed. The most common case study of a ‘non-tax dependant’ is an adult child of the deceased. However, an adult child may qualify as a ‘tax dependant’ if they are disabled, in an interdependency relationship, or financially dependent on the deceased for support at the time of the member’s death.

Where the proceeds of a life insurance policy are allocated to the deceased member’s superannuation accumulation interest, it forms part of the taxable component of that interest. This occurs by default as the insurance proceeds form part of the member’s taxable component and not included in the tax-free component.

Where a deceased member’s interest is then paid as a lump sum death benefit to a ‘tax dependant’, such as a spouse or a child under 18, the whole of the amount of the payment (including the insurance component) is tax-free. A trustee will generally not be required to calculate the tax components or withhold any tax from the payment.

Where a fund pays a death benefit as a lump sum from the member’s accumulation interest to a ‘non-tax dependant’, the trustee will need to withhold tax from the benefit payment as follows:

  • Tax-free component – Nil withholding (non-assessable, non-exempt income).
  • Taxable component (taxed element) – 15% withholding.
  • Taxable component (untaxed element) – 30% withholding.

Medicare levy/NDIS levy will also be added to the withholding, except where the death benefit is paid to the deceased member’s estate.

Where the death benefit includes insurance proceeds and the trustee has never claimed a deduction for the cost of the insurance premiums, the taxable component will include a ‘taxed element’ and an ‘untaxed element’.

The tax laws provide specific steps to calculate the taxed and untaxed elements of a death benefit lump sum. Generally, the rule of thumb is that the ‘untaxed element’ will approximate the amount of the insurance proceeds, but this is not always the case. This is best illustrated in the following case study.

Case study on treatment of life insurance

Will, aged 41, is divorced with no spouse and has one child aged 22 who is not considered a tax dependant. Will has an SMSF and is the sole member and sole director of the trustee company. The current balance of his member account is $700,000 (including a $200,000 tax free amount – personal contributions he has made and not claimed as a tax deduction) and he also has life insurance of $600,000 under the SMSF (the fund has claimed the cost of insurance premiums as a tax deduction).

Will has been a member of his SMSF since 17 October 1997 and he died on 12 October 2017 which covers a period of 7,300 days. The number of days to Will’s 65th birthday from the time of his death is 8,395 days. Using Will’s current accumulation balance of $700,000, together with insurance proceeds of $600,000, there is a total benefit payment of $1.3 million to his adult child (Will had in place a valid binding nomination to direct the SMSF trustee to pay his adult child the whole of his death benefit).

As the SMSF has claimed a tax deduction for the cost of insurance premiums, the taxable component will be required to be split between the ‘taxed element’ and the ‘untaxed element’. Applying the relevant rules, the components of the lump sum death benefit payment and applicable tax is:

Benefit componentBenefit AmountTax RateTax Levied
Tax free amount$200,0000%$0
Taxable component – taxed element$404,65117%$68,791
Taxable component – untaxed element$695,34932%$222,512
 $1,300,000$291,303

While the insurance proceeds total $600,000 you will notice that the untaxed element is higher, being $695,349. Using the general rule of thumb that the ‘untaxed element’ approximates the insurance proceeds in this case would have underestimated the amount of tax levied on the lump sum death benefit paid to Will’s adult son.

Let’s look at the effect on the calculation of the untaxed element assuming Will has a current service period of just five years more, i.e. assuming he dies on 11 October 2022 and has a future service period of five years less.

The components of the death benefit payment and applicable tax is now:

Benefit componentBenefit AmountTax RateTax Levied
Tax free amount$200,0000%$0
Taxable component – taxed element$555,81417%$94,488
Taxable component – untaxed element$544,18632%$174,140
 $1,300,000$268,628

The additional five-year service period reduces the tax liability to a ‘non-tax dependent’ by $22,675. Again, you can see that the untaxed element does not equate to the insured amount.

The importance of the eligible service date

In this case study, Will’s service period could have been extended where it was discovered that he had an eligible service date (ESD) five years earlier. This could occur where Will had rolled over superannuation from another fund to his SMSF and that other superannuation fund had an earlier ESD.

A member can effectively transfer an earlier ESD from one superannuation fund to another simply by transferring just $1 of the amount accumulated in that superannuation fund. SMSF trustees (and the fund’s accountant/administrator) should record the earliest ESD, particularly with a member with no tax dependents and insurance held within the SMSF. A member with a large service period will have relatively less ‘untaxed element’ than another member of the same age with a shorter service period. A worthwhile task would be to review for any rollovers into the fund to ascertain if any had an earlier ESD.

Once a member turns 65, they cannot have an ‘untaxed element’ in a death benefit lump sum paid to a ‘non-tax dependent’. This is due to the formulae used including future service days only up until what would have been the deceased’s 65th birthday.

So, would it have been better (for Will’s adult child) for Will’s insurance to have been held outside of his SMSF or in another superannuation fund due to the ESD?

It would be worthwhile to enquire whether members with life insurance cover have ‘tax dependants’. Where they do not, do they understand the personal income tax consequences (for the intended beneficiary) of a lump sum death benefit payment to a ‘non-tax dependant’? By checking this, the SMSF trustee would also meet the obligation under the super law to regularly review the fund’s investment strategy including insurance.

 

Mark Ellem is Executive Manager, SMSF Technical Services at SuperConcepts, a leading provider of innovative SMSF services, training, and administration. This article is in the nature of general information only and does not consider the circumstances of any individual.

RELATED ARTICLES

Limits to a will’s power over an SMSF

7 vital steps to compliance for your SMSF

Six advantages of an SMSF

banner

Most viewed in recent weeks

Noel's share winners and loser plus budget reality check

Among the share success stories is a poor personal experience as Telstra's service needs improving. Plus why the new budget announcements on downsizing and buying a home don't deserve the super hype.

Grantham interview on the coming day of reckoning

Jeremy Grantham has seen it all before, with bubbles every 15 years or so. The higher you go, the longer and greater the fall. You can have a high-priced asset or a high-yielding asset, but not both at the same time.

Five stock recoveries not hanging on COVID predictions

The focus on predicting the recovery from the pandemic is the wrong emphasis. Better to identify great companies benefitting from market changes over a three- to five-year horizon with or without COVID.

BHP v Rio v Fortescue: it's all about the iron ore price

Don’t look at an earnings forecast or a DCF valuation or a broker target price for a mining company. Share price forecasts are only as good as the commodity price assumptions they are based on, and they are a guess.

Blink and you missed a seismic shift in these stocks

Blink and it happened. If announcements in this sector were made by a producer of iron ore, gas, copper or some new tech, the news would have been splashed across the front pages. Have we witnessed a major change?

Peak to peak, which LIC managers performed during COVID?

A comprehensive review of dozens of LICs shows how they performed in the crucial 'peak to peak' of COVID. This 14 months tested the mettle and strategies of a sector often under fire, with many strong results.

Latest Updates

Superannuation

Jane Hume shakes up super, but what will it achieve?

The Government calls 'Your Future, Your Super' the most significant reforms since the start of compulsory super. Stapling has benefits and we should remove poor funds, but performance comparisons are difficult.

Superannuation

Launch of the 'Wealth of Experience' podcast

Welcome to the first episode of our fortnightly podcast, Wealth of Experience, with Graham Hand and Peter Warnes. They have a combined 99 years in markets and they will share this experience to help build your wealth.

Investment strategies

How inflation impacts different types of investments

A comprehensive study of the impact of inflation on returns from different assets over the past 120 years. The high returns in recent years are due to low inflation and falling rates but this ‘sweet spot’ is ending.

Investment strategies

Where will investment returns come from in 2021?

There are only three sources of returns when investing in companies. Whether an investment delivers on dividends, earnings or valuation expansion determines performance, and the contribution of each varies over time.

Investment strategies

Portfolio composition and what you find under the bonnet

Powerful structural themes such as technology disruption and demographic changes may disguise what is driving company success. Watch these broad categories as they may not apply in ways you expect.

Investment strategies

When rates rise, it's time to look for new players on the team

Long duration assets such as government bonds and property have benefitted from falling interest rates, but a turn is coming. It's time to find assets that may benefit from rising rates, such as private debt.

Investment strategies

How are high net worths investing and thinking now?

Citi research delves into how high net worth investors are feeling in the current market, and how they are investing during the drama of the pandemic. There is plenty of optimism and a willingness to stay invested.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.