It is a common strategy to arrange your life insurance through your super fund. The fund can often buy insurance at wholesale rates, and by using salary sacrifice, you can effectively pay the premiums from pre-tax dollars.
Tax on superannuation paid to a non-dependant
But tax may be payable on the proceeds of the policy if it is left to a non-dependant. Often a young single person has, say, $300,000 of death cover through their work super fund. They are unlikely to have dependants for tax purposes, so if they were killed in a car accident the Tax Office would take around $100,000, leaving around $200,000 in their estate.
Where tax is payable by an estate, the tax becomes a general liability of the estate. As a result things can get much more complicated if the deceased is older and the estate does not have the money to pay the tax.
Think about a single father aged 50 with three adult children who all work, and one of them lives at home with him. His house was worth $380,000 in 2008 when his will was drafted. He has $300,000 in super Fund A, and just $15,000 in super Fund B. There is also a $300,000 insurance policy in Fund B – this fund is paying the premiums because it has the smallest balance.
He wanted his will to treat his children equally. Therefore, it was drafted to give the first child the proceeds of Fund A, the second child the proceeds of Fund B and the residue of his estate to child three who was living at home. The father figured that would be the house and the contents and each child would receive roughly the same amount.
Unfortunately, the will drafter did not understand the effect of the death tax on insurance policies held in superannuation.
When the father died suddenly, the children got a terrible shock when they discovered they were not going to be treated equally at all. Ordinarily it would be thought that the first child would receive around $255,000 as the proceeds from Fund A would be taxed at 15%, while the proceeds of the insurance policy held by Fund B would yield approximately $215,000 after the tax of approximately $100,000 was deducted. Life insurance proceeds held within superannuation suffer a much higher tax than ordinary superannuation benefits because they are treated as ‘untaxed’ and are subject to 30% tax (excluding Medicare levy) when paid to a non-dependant.
Problem 1: Super funds do not deduct the death tax and send the balance to the estate. Rather, they send the entire amount to the estate - it is the estate which has the obligation to send the death tax to the ATO.
Problem 2: Because the will specifically gave "the proceeds of Fund A" to the first child and “the proceeds of Fund B” to the second child, they would be entitled to the whole of $300,000 and $315,000 respectively. The tax still has to be paid, but it won’t be coming out of the proceeds received from either of Fund A or Fund B. The executor of the estate has a responsibility of paying $145,000 to the Tax Office ($45,000 death tax on Fund A and $100,000 death tax on Fund B).
Estate left to pay the tax
Because children one and two have received specific bequests, the tax can only be paid out of the residue of the estate. Using a concept known as ‘marshalling’, the executor will probably have to sell the home to pay the $145,000 tax bill leaving child three with net benefits of only $105,000. Not only has the third child borne the cost of the tax payable on both of the superannuation payouts, but the family home has been sold to pay the tax bill.
It is critical that anyone drafting a will understands that all assets are not treated equally for tax purposes. The difference between CGT-free assets like the family home, and investment properties that carry a CGT liability, are generally well known. But few understand the tax treatment of insurance policies held within superannuation, let alone the different tax treatment of the various components arising from contributions made to superannuation funds. As the above example shows, failure to take this tax into account can have disastrous and unforeseen consequences.
Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance. His advice is general in nature and readers should seek their own professional advice before making any financial decisions. His website is www.noelwhittaker.com.au.