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How to avoid paying out a 'death duty' tax in SMSFs

SMSF trustees must keep adequate records of contributions to avoid paying out a 'death duty'.

When a fund member dies, the payout to non-financial dependents may be liable for tax, with the amount dependent on the category of contributions made to superannuation. The 'death duty' tax affects all superannuation funds but it is more likely to be significant in self-managed funds because of the extra contributions above the contribution guarantee that members have made over the years.

Tax applies on the death of anyone who still has assets in a superannuation fund and who has nominated beneficiaries to receive a payout upon their death. If the payout goes to a financial dependant, including a spouse or child under the age of 18 – it is tax-free. However, if it is paid to non-financial dependants, the proportion of any payout that is deemed to be from the taxable component will be taxed at 16.5 per cent.

It is therefore important for trustees, and their advisers, to keep track of the type of contributions being made to superannuation. This includes categories such as how much is after-tax contributions (that is, member non-concessional contributions), how much represents taxable employer, or taxable personal, contributions, and the like.

These amounts should be summarised however, with some SMSFs, this record-keeping might not be as disciplined as it should be. In particular, fund members should check their balances and the component percentages of contributions, and be aware of these ramifications.

Keeping track of taxable and tax-free components can be problematic for members of SMSFs where manual records are kept, or where their SMSF is administered by an accountant who does not have specialised superannuation fund software. Not only does this issue muddy the tax waters upon death but can create issues for the trustees if the fund were to be audited by the ATO.

Without proper records of the taxable and tax-free components of member benefits, the ATO could deem a member's death benefits to be taxable which can add up to a serious amount if the death benefit is large. This outcome may seem unfair, but the onus is on the fund or beneficiary to prove otherwise.

There are steps that could be taken to reduce the tax payable by beneficiaries. For example, there is no tax liability if the member is over age 60 and withdraws all superannuation balances shortly before death. Also, fund members aged over 60 with a large proportion of taxable benefits may consider the 're-contribution strategy' whereby 'taxable' fund benefits are withdrawn tax-free, and then 're-contributed' to the fund as a tax-free non-concessional contribution.

Members wishing to carry out the strategy should ensure that, firstly, they are eligible to withdraw benefits from their fund. Secondly, they need to ensure that they are still eligible to contribute to superannuation – that is, they are under age 75, or if over 65 but under age 75, they meet the contributions work test.

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