By Colin Lewis, Head of Strategic Advice, Fitzpatricks Private Wealth
October 2024

Unlike the days of old, the current superannuation system is cleverly designed to prevent the creation of ‘family dynasties’ with super.

At the front end, the contribution caps and total superannuation balance (TSB) test restricting certain contributions, limit how much can go into it.

And at the tail end, the operation of the transfer balance cap (TBC) ensures that benefits in super ultimately get paid out.

On death, your super must be paid as a lump sum and/or income stream as soon as practicable, but generally within six months of passing, unless you have a reversionary pension where the income stream automatically continues.

Benefits on death cannot be retained by a beneficiary, e.g. spouse, in super unless it’s paid as a pension.

One advantage of receiving a pension on death is the deceased’s super remains invested in an environment where earnings and capital growth are tax-free.  Additionally, it may mean not having to sell a property or other ‘lumpy’ asset in an SMSF to pay a lump sum death benefit, provided the fund has the liquidity to meet the minimum pension requirements.

Whilst the TBC restricts the amount that can be moved into the tax-free retirement phase when commencing say an account-based pension, it also applies to pensions received on death and this is where it may get you.

If your super is well within the TBC – like with most people – then you have nothing to worry about.  However, it can be a different story where you combine it with your spouse’s super when one of you passes away as it can force the withdrawal of benefits in excess of the surviving spouse’s TBC.

Who can receive a super pension on death?

Only certain beneficiaries can receive a pension on death.  They are your spouse, a person with whom you are in an interdependency relationship, someone financially dependent on you and a child under 18 years of age, or 18 but less than 25 and financially dependent on you, or 18 or more with a disability.

A child receiving a pension must withdraw it as a tax-free lump sum no later than their 25th birthday, unless they suffer from a disability.

You may not have thought about leaving your super to the kids.  Your spouse may have been front of mind and your beneficiary nomination structured for them to receive the lot, but if you’re hoping for them to keep as much of your benefit in super as possible – maybe your SMSF owns a property you don’t want liquidated – then a problem could arise where they’re limited by their TBC.

This is where kids may come in handy.

The TBC and pensions on death

The TBC limits death benefit income streams and reversionary pensions.  Any pension on death exceeding an eligible beneficiary’s TBC must be cashed out of super.

The general TBC is $1.9 million, but a lower personal TBC may apply where you’ve commenced a retirement phase pension, e.g. account-based pension, or received an income stream on death.

Careful planning is required where your beneficiary will exceed their TBC from receiving an income stream on death as they’ll need to arrange their affairs – by commuting some or all of their pension back to accumulation phase – to prevent this happening.

If the aim is to retain the maximum possible amount in super, it may be possible to structure your death benefits nominations, that once your spouse’s TBC is exhausted, the excess goes to eligible children where they receive a concessionally taxed income stream from the tax-free environment.

Where a child receives a death benefit pension, a modified TBC – ‘cap increment’ – applies to recognise the pension is temporary – generally paid only until age 25.

The value of a death benefit pension paid to a child depends on whether the parent had ever started a retirement phase income stream – excludes transition to retirement pensions not in retirement phase.

Where the parent had commenced a retirement phase pension, the child’s cap increment is their share of the deceased’s pension balance.

However, if the parent had never commenced a retirement phase pension, the child’s cap is their portion of the general TBC corresponding to their share of the death benefit.

Example

Homer and Marge have an SMSF which owns a property valued at $2.5 million and has $100,000 in cash.

Both Homer and Marge have account-based pensions.  Homer’s pension is valued at $2.1 million, and Marge’s pension is worth $500,000 – she started this pension with $400,000 on 1 June 2020.

On 1 August, Homer died with a binding nomination directing the trustee to pay his super to Marge.

Marge wishes to keep the property in the SMSF, so she aims to take Homer’s death benefit as an income stream.

Marge’s personal TBC is $1.825 million – using only 25 per cent of the original $1.6 million cap, her TBC has been indexed twice, the first time by $75,000 and the second time by $150,000.

Marge transfers her pension back to accumulation phase before receiving the death benefit pension, but being restricted by her TBC, she can only commence a pension with $1.925 million ($1.825 million – $400,000 + $500,000), leaving $175,000 to be cashed out of super.

As the SMSF has only $100,000 in cash, the property may need to be sold.

Marge may be able to inject liquidity into the fund by making a non-concessional contribution – her TSB at 30 June 2024 was less than $1.9 million.

If Marge is unable to contribute, the SMSF could make an in specie benefit payment – deed permitting – resulting in the property being owed tenants in common by the SMSF and Marge.

Had Homer’s nomination been non-binding, the trustee would have had the flexibility to pay their son Bart (17) a small death benefit pension – keeping the property in the fund for the time being.

Given Homer had an account-based pension, Bart’s cap increment is his share of Homer’s pension balance.

So, the trustee could have paid Marge a death benefit pension worth $1.925 million so as not to exceed her TBC, and Bart a pension of $175,000 – his cap being 8.33 per cent of $2.1 million.

If Homer’s benefit was instead in accumulation phase and he’d never started a pension, the outcome would be different as Bart’s pension would be limited to his portion of the general TBC corresponding to his share of Homer’s death benefit.

Again, the trustee could pay Marge a death benefit pension worth $1.925 million but Bart’s pension this time would only be $158,333 (8.33 per cent of $1.9 million), leaving $16,667 to be withdrawn from super which the fund has the cash to do.

While providing for children via your super can be appealing, be aware that they could rush out and spend it the moment they turn 18 as generally nothing prevents them withdrawing it at that age.

As you can see, careful planning is required.