Super inheritance: Tax strategy that could save your kids cash

While Australia doesn’t have a specific inheritance tax, super that hasn’t been taxed previously may instead be taxed when you pass it on to your family in your will. When this happens, the Australian Tax Office (ATO) can take a large portion, shrinking the inheritance you pass on to your loved ones.

You may have heard some recent talk of a viral ‘withdrawal and recontribution’ superannuation strategy, which some have suggested is a way to help your kids inherit more of your super. So what is this strategy, how is it meant to work, and what should you potentially be wary of?

How is superannuation taxed in Australia?

As Benjamin Franklin once said, “in this world, nothing can be said to be certain, except death and taxes”. Because superannuation is meant to support you in your retirement and lessen your need for government benefits, it’s generally not taxed heavily when you’re alive, but it’s a different story when you pass on.

How super is taxed during your lifetime

A big portion of your superannuation is generally untaxed, as it is made up of pre-tax income from the super guarantee and any concessional contributions from salary sacrifice arrangements, plus wealth grown from the super fund’s investments. Part of the balance may also be made up of previously taxed money, such as non-concessional voluntary contributions you make out of your post-tax income.

As your superannuation balance is intended to help support you in your retirement, reducing or eliminating your reliance on a government pension, Australians who fulfil the necessary eligibility criteria can access a lump sum from their super fund without paying tax.

How super is taxed after you pass away

According to the ATO, if your lump sum death benefit is paid to your surviving spouse, dependent children (e.g. aged under 18), or another dependant, the whole amount is tax-free. This is the case whether the lump sum contains a taxed element or an untaxed element.

If your previously untaxed super is inherited by a beneficiary who is not a dependent child (such as your adult children) as a death benefit, the tax office considers this to be income, meaning that it can be taxed. The exact tax rate can vary depending on the beneficiary’s age and financial situation, but can be as high as 32%. This means that even if you leave a super balance of $1 million as inheritance for your children, the ATO could potentially take as much as $320,000 in taxes, effectively reducing the inheritance by almost a third.

What is withdrawal and recontribution?

In short, this strategy involves making a tax-free withdrawal of part of your super balance, then depositing it back into the fund as a voluntary contribution. This effectively changes the money’s status from untaxed to taxed. According to the ATO, “any amount you withdraw and re-contribute to your super fund is counted as a new non-concessional contribution”.

For example, if you had an untaxed super balance of $1 million, you could hypothetically make a tax-free withdrawal of $360,000, then make a voluntary contribution back into the fund. This would give you an untaxed balance of $640,000 and an effectively taxed balance of $360,000. If you were to pass away, assuming your adult children were being taxed at a rate of 32%, they could inherit $795,200 in total ($640,000 – $204,000 + $360,000), rather than the $680,000 they would have previously.

Given enough time, and careful management of your super, it may be possible to gradually transfer the full balance over to taxed status, which could let your beneficiaries inherit the full balance upon your passing without the ATO taking a percentage.

What should you look out for?

It’s very important to be aware that a withdrawal and recontribution strategy isn’t always as simple as it sounds. To start with, to make tax-free withdrawals from your super fund, you’ll need to fulfil the appropriate eligibility conditions. This often includes being aged over 60 and satisfying a condition of release.

Secondly, the ATO caps the amount of non-concessional deposits you can make per year. This means the maximum amount you could use this strategy for is $120,000 per year, or up to $360,000 by making three years’ worth of withdrawals in advance under the Bring It Forward rule.

It’s also essential to keep in mind that the ATO may consider some tax-minimisation strategies as tax avoidance or tax evasion, which could lead to criminal prosecution in some cases. Superannuation and taxation rules are also complex, with many exceptions, terms and conditions, so Withdrawal and Recontribution may not always be the best option for you.

Before making any changes to your super or tax arrangements, it’s important to seek professional advice from financial advisers, tax accountants and legal experts.

Where can you get professional estate planning help?

Estate planning is important to consider so you can be confident that your wealth will be fairly distributed to your loved ones following your passing. Remember that superannuation and taxation rules are regularly updated and can change over time. Rather than setting and forgetting your estate plan, it may be worth checking in every few years to make sure it is still up to date. It may also be worth contacting the ATO itself to confirm what tax rules may apply to you and your loved ones. As the ATO says: “Beware of schemes that claim to have estate planning purposes but are merely tax avoidance arrangements. An effective tax governance framework includes processes for evaluating various arrangements and the tax risks involved.”