By Monica Rule

You just never know what each new day will bring and unfortunately for some the new day could be their last on earth. Sudden and unexpected death or disability does happen and I am sure that if you haven’t been directly affected by this then you know of someone who has. This article is intended to help you understand the different options that are available on your superannuation entitlements if ever you are faced with a death or disability.

If a Self Managed Superannuation Fund (SMSF) member is diagnosed with a terminal illness, they will need to consider how they would like their superannuation entitlements to be paid to them.  They could consider taking their superannuation entitlement as a terminal illness benefit or as a permanent disability benefit.  They could even have their entitlements paid as a death benefit to their family upon their death.

The type of superannuation benefit to choose will of course depend on a person’s financial circumstances at the time of the event.  However, it pays to understand the tax treatment of such benefits as it could make a difference on how much is passed onto your family instead of to the Taxation Office.

Terminal illness benefit 
For a benefit to be released under terminal illness grounds, an SMSF member will need to satisfy the following conditions:

• two registered medical practitioners have certified, jointly or separately, that the person suffers from an illness, or has incurred an injury, that is likely to result in their death within twelve months, and;
• at least one of the registered medical practitioners is a specialist practising in an area related to the illness or injury, and;
• the benefit is taken within twelve months of the certification.

The member can elect to receive the payment either as a lump sum benefit or an income stream benefit (e.g. a pension). 

If the member elects a lump sum benefit, the benefit will be paid to the member tax-free, regardless of the member’s age.  For the payment to be tax-free, the person must have a terminal medical condition at the time the payment is received or within ninety days after the payment is received.

If the member elects to receive a pension benefit, the benefit is taxed as a normal superannuation income stream.

As to what form (e.g. lump sum or pension) of terminal illness benefit the member can take will depend on their SMSF’s trust deed.  If their SMSF only allows for a lump sum, then the member would be unable to take their benefit as an income stream benefit.   

The member also needs to be careful if they are considering transferring their terminal illness benefit to another superannuation fund for payment as an income stream. Under the Income Tax Assessment Act 1997 the transfer would not be treated as a rollover and therefore would count towards the member’s non-concessional contribution cap when the new superannuation fund receives the funds.  This could result in the member exceeding their non-concessional contribution cap and incurring an excess contributions tax liability.

On the other hand, if the member elected to have their superannuation savings transferred to another superannuation fund prior to applying to have their benefit released on terminal illness grounds, then it would be treated as a roll-over which means it would not count as a contribution to the new superannuation fund.

A terminally ill member may also consider applying for a benefit under permanent disability grounds.  If eligible they can choose to take the benefit as a lump sum permanent disability benefit instead of as a terminal illness benefit.  However, the tax treatment will differ as I will explain below.

Permanent disability benefit
To access money under permanent disability grounds, the trustee of an SMSF must be reasonably satisfied that the member is unlikely to engage in gainful employment in a capacity for which the member is reasonably qualified by education, training or experience.  A medical certificate is not a requirement under permanent disability grounds.  It is up to the trustee as to what standard of proof they require to enable them to be reasonably satisfied that the definition has been met.

A permanent disability benefit can also be paid in the form of a lump sum or an income stream.

If a person chooses to take the benefit as a lump sum, the tax treatment will differ from a terminal illness lump sum benefit.  The entire lump sum is tax-free if paid to a person aged 60 and over. If a person is aged less than 60 then tax is payable on the lump sum depending on the components of the lump sum. 

A lump sum permanent disability benefit qualifies for an increased tax-free component, where two legally qualified medical practitioners have certified that, because of ill-health, it is unlikely that the person can ever be gainfully employed in a capacity for which they are reasonably qualified because of education, experience or training.  The increased tax-free lump sum amount is calculated using the following formula:

                Amount of benefit      x                Days to retirement
                                                                Service days + days to retirement

Days to retirement is the number of days from the day on which the person stopped being capable of being gainfully employed to their last day of work (for most people this will be their 65th birthday).

Service days is the number of days in the service period for the lump sum.

Example 1:  Bev had an accident that stops her from being able to work on 3 September 2007.  She received a permanent disability lump sum benefit of $160,000 from her SMSF.  Her days till retirement (the day she turns 65) are 6512.  Her number of days in service is 8099.  The total value of Bev’s superannuation account is $400,000 – which is made up of a tax free component of $100,000 and a taxable component of $300,000 made up solely of an element taxed in the SMSF.

Bev’s permanent disability lump sum benefit of $160,000 will therefore consist of a 25% tax free component and a 75% taxable component (i.e. $100,000/$400,000), that is $40,000 tax-free and $120,000 taxable.

                   $160,000   x        6512         =     $71,310.68 additional tax-free amount
                                          6512 + 8099

Bev’s total disability lump sum benefit paid from her SMSF will be $71,310.68 + $40,000 = $111,310.66 tax-free and $46,689.34 which is the taxable component.  The tax treatment of the lump sum will be as per normal lump sum benefits paid from a complying superannuation fund.

If a person chooses to take the permanent disability benefit as an income stream, they are not entitled to the calculation of a larger tax-free portion.  The income stream is taxed at the person’s marginal tax rates with a 15% tax offset available if the person is under the age of 60.  If the person is aged 60 or over, then the disability income stream is tax-free.

Again trustees of SMSFs must follow the rules in their SMSF’s trust deed as to whether benefits can be paid out under permanent disability grounds as well as the form of the benefit.

Death Benefit
Death benefits are mainly paid as a lump sum.  A death benefit can be paid as an income stream to the deceased’s spouse, the deceased’s child under  18 years of age or a child aged 18 or over who is financially dependent on the deceased and is less than 25 years of age or has a disability.  This means a child who is considered a dependant of a deceased member can receive a death benefit pension until the age of 24 or longer if the child suffers a disability.

The tax treatment of a lump sum death benefit depends on whether the recipient is a dependant or a non-dependant of the deceased member. 

A dependant is defined as:

• a spouse or former spouse of the deceased (including a spouse of the same sex)
• a child of the deceased under the age of 18
• a person financially dependent on the deceased at the time of death
• a person who had an interdependent relationship with the deceased just before death 

A lump sum death benefit paid to a dependant is tax-free. If it is paid to a non-dependant, then tax is payable at 0% on the tax-free component, a maximum of 15% on the taxable component, and a maximum of 30% on the untaxed component. The Medicare levy is payable whenever the tax rate is greater than 0%.  Also if a death benefit is paid to dependants they may be able to take advantage of the anti-detriment provisions and receive a larger death benefit.

An anti-detriment payment is essentially a refund of the 15% contributions tax paid by an SMSF.  It is an additional amount that may be paid if a lump sum death benefit is paid to a dependant of the deceased member.  Its purpose is to provide a death benefit of an amount that would have been payable if contributions tax was not deducted from the deceased member’s account.

The tax payable on a death benefit income stream depends on the age of the deceased, the age of the recipient and the component of the income stream.  The Medicare levy is payable whenever the tax rate is greater than 0%.

Other considerations
There are other considerations which should be examined.  For example:

• an anti-detriment payment is not payable if a benefit is accessed under a terminal medical condition or a permanent disability condition,  as it is only payable on death benefits; 
• it is important to consider whether your SMSF holds any life insurance for you prior to rolling money into another superannuation fund, and;
• if you receive a lump sum terminal illness benefit, it may affect your entitlement to a disability support pension.

Superannuation savings are important whether you enjoy them in retirement or pass them on to your dependants when you die.  Carefully considering how your savings will be passed on to your loved ones once you are gone could be one of your greatest legacies.

For Gold and Platinum members please read on for the different tax treatments of an income stream superannuation benefit payable under a terminal illness ground and disability ground; a lump sum superannuation benefit payable under a permanent disability ground; and an income stream death benefit payable to dependants .

This article was prepared by Monica Rule. Monica Rule worked for the Australian Taxation Office for 28 years, is a SMSF Specialist Advisor, and is the author of The Self Managed Super Handbook.  Monica is running SMSF Seminars in various states.  For more details visit  www.sunshinepress.com.au.

Build these documents now:

• Self Managed Superannuation Fund Deed
• SMSF - Deed Update
• Webinar Recording - The Protected Super Myth’Conception
• Webinar Recording - Accountant Road Rules for Super
• Webinar Recording - Investment Restrictions for Self Managed Superannuation Funds