In last week’s article, we examined recent amendments relating to death benefit pensions.
This week, we look at whether a reversionary or non-reversionary pension may be better. The decision is not straightforward and depends on the circumstances of the case.
In the case of a non-reversionary pension, the balance of the pension at the time of the pensioner’s death retains the same taxable and tax free proportions, but amounts which relate to anti-detriment and the proceeds of an insurance policy will have their own taxable and tax free amounts. In some cases, this may be to the advantage of the beneficiary and in others it may not. It all depends on the age of the pensioner at the time of death and whether the superannuation fund may have claimed a tax deduction for insurance premiums. In the case of an SMSF the funding of an anti-detriment payment is an issue which usually involves transfers of amounts from reserves and may result in issues with breaches of the excess concessional contributions caps – to be avoided at any costs.
In the case of a reversionary pension, the proportioning rule retains the taxable and tax free components of the original pension irrespective of whether the proceeds of an insurance policy are added to the pension balance after it has commenced.
Here is a case study to compare how these rules operate for the proceeds of an insurance policy:
Take the example of Ray who is age 58 and his wife Paula who is 55 and was in receipt of a transition to retirement income stream which was reversionary at the time of her death. The balance of Paula’s income stream at that time was $400,000. Under the proportioning rule the income stream was split 80% taxable proportion and 20% tax free proportion. Paula was insured in the fund for $1 million which was paid subsequent to her death. The fund had claimed a tax deduction for the premiums on the policy. Under the rules of the fund the proceeds of any insurance policy may be added to any death benefit at discretion of the trustee. As trustee, Ray exercised the discretion and added it to the pension. Any pension payable to Ray will be taxed on the taxable proportion as he and Paula were under age 60 at the time of Paula’s death.
As the superannuation fund had claimed a tax deduction for the premiums on the policy the amount received from the proceeds of the insurance policy would be treated as a taxable component. However, as it is permissible to add the insurance proceeds to a pension that is already in place then the proportions that applied at the commencement of the pension will continue. This means that the 80% taxable and 20% tax free proportion will continue despite the addition of the insurance component which notionally has a higher taxable component.
If Paula had decided to commence a non-reversionary pension the rules differ due to the changes to the superannuation legislation which were backdated to commence from 1 July 2012. As the pension ceased at the time of Paula’s death the proportions of 80% taxable and 20% tax free will remain with the balance of the pension. This means that the $400,000 being the balance of Paula’s pension account on death will consist of $320,000 taxable and $80,000 tax free amounts. As the proceeds of the insurance policy consist of a taxable component they will be added to the taxable amount. The effect will be to increase the taxable component to $1.32 million and the tax free amount of $80,000 will remain unchanged. Therefore the resulting taxable proportion will be approximately 94% and the tax free component will be approximately 6%. This means that any pension paid will have a greater taxable portion than if Paula had been paid a reversionary pension.
In this case, it would have been better for Paula to have commenced a reversionary pension and Ray receives it as a reversionary on her death. As a general rule, where the proceeds of an insurance policy are expected and will be added to a pension after the death of the original pensioner, a reversionary pension would appear to provide the best results from the point of view of the taxable and tax free proportions. This is relevant prior to both the original pensioner and the reversionary reaching age 60 and subsequently on the death of the reversionary pensioner if the residual amount of the reversionary pension is paid to a non-dependent child as defined for taxation purposes.
Benefits from the changes to the law for non-reversionary pensions
The main benefit arising from the amendment to the law which applies from 1 July 2012 is that trustees of superannuation funds that pay non-reversionary pensions now have greater flexibility to dispose of assets after the death of the pensioner and retain the tax exemption which applied to the pensioner prior to their death.
Similar treatment also applies to the calculation of the tax free and taxable components that applied to the non-reversionary pension. That is, the taxable and tax free proportions applying to the non-reversionary income stream will continue to apply to any lump sum or subsequent pension that arises from the pension assets at the time of death.
While this may sound relatively straightforward, care needs to be taken where amounts from anti-detriment payments or the proceeds of insurance policies are added to the superannuation income stream account. It may turn out in some cases that there may be a greater benefit provided in relation to the taxable and tax free components if a reversionary pension is payable and the proceeds of the insurance policy is added after the reversionary pension has commenced. The reason is that the proportioning rule is not re-calculated despite the fact that technically the proceeds from the insurance policy may include a relatively high taxable component. This, as always, depends on the circumstances of the particular case.
Graeme Colley is the Director Technical & Professional Standards at SPAA, the SMSF Professionals’ Association of Australia.