Essential superannuation estate planning

By Julie Steed, Technical Services Manager 

The payment of a death benefit from a superannuation fund to a surviving spouse or a minor child can be very tax-effective. However, there are often situations where clients have estate planning goals that are more compelling than just tax minimisation. These may include ensuring that vulnerable beneficiaries are protected or that assets are available for distribution to non-tax dependants, including charities.

The use of testamentary trusts can provide estate planning certainty for clients with vulnerable beneficiaries and also allow for the tax-effective distribution of income between family members. These can be combined with a life interest trust to balance providing for dependant beneficiaries with distributing assets to other parties who are not financially dependent.

What is a testamentary trust?

A testamentary trust is a trust that is created within and by a person’s Will, but does not take effect until after their death. A testamentary trust may be created using specified assets, a designated portion of an estate or the entire remaining balance of an estate. Multiple testamentary trusts may be created by the one Will.

What is a testamentary life interest trust?

A testamentary life interest trust provides support to a beneficiary (such as a surviving spouse) following a client’s death, for the remainder of their life. Once the beneficiary no longer needs support, the estate will be distributed according to the instructions outlined in the client’s Will. These types of trusts are commonly used to provide income to a surviving spouse during their lifetime, with the assets passing to the children upon the spouse’s death. They are particularly popular for clients with blended families or second marriages or families with difficult relationships.

The defining feature of a life interest trust is that the primary beneficiary does not control access to the capital of the trust. When the trust vests (ie when the life interest period ends) or is no longer required, the terms of the client’s Will dictate who receives the assets that are subject to the life interest.

What are the advantages of a testamentary trust?

There are a number of advantages of creating a testamentary trust including:

  • flexibility for the primary beneficiary
  • protection of beneficiaries
  • protection of assets
  • taxation advantages.

Flexibility for the primary beneficiary

If included within the terms of the trust, the trustee can exercise discretion as to the distribution of income to beneficiaries at any time and in any proportion. There may be tax planning reasons for the primary beneficiary to request the allocation of income to a number of beneficiaries or the primary beneficiary may simply not require as much financial support as the client has allowed in their Will.

If the primary beneficiary has no need for the trust, it can be wound up at any time and the trust capital will be distributed in accordance with the instructions in the client’s Will.


Protection of beneficiaries

Many parents appreciate the tax efficiency of paying superannuation death benefit pensions to minor children, but balance this with their fear of what their 18 year old may do with a large sum of money – a superannuation death benefit income stream can generally be commuted at age 18.

In an SMSF this may be addressed by using a trust deed clause that restricts the commutation to age 25. However, this is not an option in many SMSF deeds, nor is it an option in public offer funds.

Directing some or all of the superannuation balance to a testamentary trust can address this issue as the parents can control when children have access to funds.

In addition to minor beneficiaries, many clients will have other beneficiaries who will benefit from not having direct control over an inheritance. These can include spendthrift beneficiaries, those with gambling, alcohol or drug addictions or people who are easily influenced by others.


Protection of assets

As the assets of the trust are not legally owned by the beneficiaries, the assets are generally better protected from legal proceedings, such as the beneficiary’s relationship breakdown or bankruptcy.

The use of a testamentary trust provides a level of protection if and when a relationship breaks down. This is because the assets are held in a trust and the income and capital are distributed at the discretion of the trustee (who generally would not be the child in the difficult relationship). In the event that a beneficiary becomes bankrupt, the assets are generally better protected.

If a Will simply leaves assets directly to a beneficiary, in bankruptcy, an inheritance may pass straight through to the trustee or to creditors.


Taxation advantages

Taxable income generated by the trust can be retained by the trust or allocated to the beneficiaries in a tax-effective manner. The trustee can be given discretionary powers in relation to the distribution of income which makes the testamentary trust a flexible tax planning vehicle.

Beneficiaries pay income tax at their individual marginal rates on the amount of income they receive from the trust. However, unlike tax on income from a family trust, beneficiaries of testamentary trusts under age 18 are taxed at normal adult rates rather than the penalty tax rate applied to minors. As a result, the potential for tax savings when trust income is allocated to children can be substantial.

Family home

A regular provision of a Will is to provide a right for a surviving spouse to reside in the family home for their lifetime. Where it is a client’s intention to provide such a right, it is essential to account for events such as downsizing, ill health, moving into aged care or other changes in family circumstances. It is common for the life tenant to have the right to sell the property and purchase another residence on the same terms that were established in the Will for the first residence. The subsequent purchase will be in the name of the executor of the estate and the surviving spouse as tenants-in-common. The treatment of any surplus on the sale and purchase also needs to be considered and documented.

It is also important to consider how other expenses incurred - insurance, rates and other expenses for maintaining the home are to be paid for. Commonly, the life tenant will be responsible for paying expenses from other income producing assets in the trust. Alternatively, the estate may be responsible, however, this requires very careful drafting in the terms of the Will.

Consideration also needs to be given as to how the furniture and contents of the home are to be treated in the Will. Generally, these will be passed directly to the beneficiary who has the right to reside in the home.

Great care needs to be taken in drafting the Will and we advise seeking professional estate planning advice to prevent unexpected outcomes.  There is not necessarily a right or wrong way to deal with these issues provided that they are all identified, discussed and documented.

Case study - Vincent and Mia

Vincent and Mia have been married for two years and are both 56. They both have two adult children from previous marriages and have four grandchildren. They have a comfortable lifestyle and currently have the following income and assets:

Ownership Source Annual income
Vincent Salary $250,000
Vincent Investments $60,000
Mia Salary $100,000
Total $410,000

Ownership Asset Asset value
Tenants-in-common Family home $1,600,000
Joint Cash $100,000
Vincent Shares $1,200,000
Vincent Superannuation $1,200,000
Mia Superannuation $400,000
Total $4,500,000

If one of them was to die, they want the survivor to be able to maintain a comfortable lifestyle and remain in the same home. Upon the death of the surviving spouse, they want all four children to benefit relative to the assets their parent’s brought to the relationship.

As Vincent and Mia are both over preservation age, in order to maximise the tax efficiency of investment returns, they both have transition to retirement pensions (with 100 per cent taxable components) for the majority of their superannuation.

Estate planning

Vincent and Mia contributed equally to the purchase of their home and they structured the ownership as tenants-in-common. This means that if one of them were to die, the survivor does not automatically own the whole home. They each own half of the house and can therefore deal with their half in their Will, and eventually pass their share to their own children.

Vincent and Mia have Wills prepared which provide a life interest for the surviving spouse to live in the family home. Vincent completes a nomination in his SMSF which compels $400,000 of his death benefit to be paid to Mia and the balance to be directed to his estate, along with his share portfolio. These funds will be used to create a life interest trust on his death with the trust income paid to Mia and the capital paid to Vincent’s children, following Mia’s death. Vincent acknowledges that this may not be as tax-effective as passing all of his superannuation to Mia, however, he is keen to ensure that Mia maintains a comfortable lifestyle whilst leaving the remainder of his estate to his children.

Mia’s Will also provides a life interest for Vincent to live in the family home. However, as Mia’s superannuation is relatively modest in comparison to Vincent’s income and she has no other assets, her superannuation will be paid to her children.

Both of their Wills provide that the family home may be sold or replaced, with any excess capital proceeds to be held in trust. The income from the sale proceeds trust can be used to fund aged care expenses or maintain a replacement property. However, any residual capital will pass to the four children equally.

Estate plans in action

A short time passes when Vincent dies suddenly in a road accident and their estate plans are activated.

Mia continues to live in the house and receives a $400,000 tax-free payment from Vincent’s superannuation. She retains her job and salary and has access to income from the trust created from Vincent’s shares and the balance of his superannuation. The trust allows Mia to distribute the income to herself, her children or grandchildren, Vincent’s children or grandchildren or nominated charities. The capital of the trust remains protected for Vincent’s children.

In the first year, the trust produced the following investment returns:

Investment return Amount
Interest $14,000
Dividends $66,000
Total income $80,000
Imputation credits $28,000

$10,000 of the trust income is used by the trustee to pay for expenses on the property and $70,000 is distributed to Mia. Mia’s tax position is then as follows:

Income Before Vincent's death After Vincent's death Difference
Salary $100,000 $100,000 nil
Trust distribution nil $70,000 $70,000
Net income received $100,000 $170,000 $70,000
Imputation credits nil $28,000 $28,000
Total taxable income $100,000 $198,000 $98,000
 

Tax payable Before Vincent's death After Vincent's death Difference
Tax on taxable income $26,947 $66,967 $40,020
Less imputation credits nil $28,000 $28,000
Total tax payable1 $26,947 $38,967 $12,020
Net cash received (net income - total tax) $73,053 $131,033 $57,980

As the trust allows discretion as to how the income is distributed, Mia can generate tax efficiencies by distributing income to the grandchildren. Mia requests that the trustee distribute $17,500 to each grandchild. The tax position of the distribution for each child is then as follows:

Assessable income Per child Total
Distribution $17,500 $70,000
Imputation credits $7,000 $28,000
Total assessable income $24,500 $98,000

Tax payable Per child Total
Tax on $24,500 $1,148 $4,592
Less imputation credits $7,000 $28,000
Tax refund $5,852 $23,408
Net cash received $17,500 + $5,852) $23,352 $93,408

By having the flexibility to distribute income to the grandchildren, Mia has increased the total disposable cash for the family unit by $35,428 ($93,408 - $57,980).

Testamentary trust versus SMSF income stream

If all of Vincent’s superannuation had been paid to Mia as an income stream and she drew down the minimum annual pension amount she would be paying $11,520 in tax.

Superannuation pension Amount
Account balance $1,200,000
Minimum annual pension ($1,200,000 x 4%) $48,000
Tax on $48,000 ($48,000 x 39%)2 $18,720
Less 15% tax off-set ($48,000 x 15%) $7,200
Net tax payable $11,520

If Mia took $400,000 as a tax-free lump sum and then drew the minimum annual pension amount from the remaining $800,000 of Vincent’s superannuation, she would still be paying $7,680 in tax. 

Superannuation pension Amount
Account balance $800,000
Minimum annual pension ($800,000 x 4%) $32,000
Tax on $32,000 ($32,000 x 39%) $12,480
Less 15% tax off-set ($32,000 x 15%) $4,800
Net tax payable $7,680

In this case study, receiving a death benefit pension from the SMSF is not as tax-effective as using a testamentary trust to distribute income amongst the family. In addition, Vincent will achieve his objective of leaving assets to his children.

A few years later Mia wishes to move to a smaller home. The family home is sold for $2 million and Mia purchases a bungalow at the beach for $1.2 million. The $800,000 change-over is invested in a trust as provided by Vincent’s Will. The income from the trust can be used to maintain the property, with any additional income available to Mia. The capital will be preserved for distribution to all four children following Mia’s death.

Conclusion

A regular review of a client’s individual circumstances ensures their estate planning goals are being met. Both testamentary and life interest trusts can be effective estate planning structures for clients seeking to balance tax minimisation with distributing wealth to their desired beneficiaries.
  

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1 Based on 2014/15 tax rates including Temporary Budget Deficit Levy
2 As Mia’s total income remains below $180,000 the additional tax calculation is simply the additional income multiplied by her marginal tax rate of 39 per cent, including Medicare levy