Nick Bruining: Your easy-to-follow guide to dodging the super death tax with a recontribution strategy

Older superannuation fund members can use the last three months of the financial year to complete a strategy which has the potential to save your kids as much as $86,000 in super death tax.

The strategy can be used by anyone, and even those with only modest amounts in retirement savings can benefit.

It revolves around a popular technique called recontribution, but also makes clever use of the contribution rules and upcoming changes.

It’s a no-brainer for almost anyone with money in superannuation. But if you do things in the wrong order or mistime the move, it can become messy and, potentially, expensive.

To understand how the strategy works, you need to understand how tax works in the superannuation system.

The first of two tax components

Almost all superannuation money is assigned to one of two components. If you get a tax statement from your super fund, you will see them listed. These components exist in both accumulation and retirement phase accounts.

The taxable component is exactly that — subject to tax. But for most seniors over the age of 60 who make a withdrawal from super, another rule means no tax is payable. It doesn’t matter if it is a monster lump-sum withdrawal or a small regular payment. There’s no tax. We’ll be making use of that fact later.

The taxable component is made up of concessional contributions including compulsory employer super, salary-sacrificed super and contributions that you claimed a tax deduction for. Any earnings of the fund are also part of the taxable component.

When you die and the remaining super is paid to anyone other than a financial dependent — such as your partner or spouse — tax is payable. The tax rate is 15 per cent and, if paid directly to individuals such your kids, the Medicare levy is also payable.

This will be at least 2 per cent but may be higher if the recipient doesn’t have adequate private health insurance cover in place.

The only way to avoid the cost is to pay the proceeds to your estate because it isn’t an entity that’s liable for the levy. From the estate, your will can then distribute the money. That way, the kids won’t even need to put the inheritance in their tax return.

. . . and the second one

The other component is the tax-free component and, not surprisingly, is always exempt from tax — no matter who the recipient is. It is typically made up of personal non-concessional contributions, super downsizer contributions and government co-contributions.

In almost all super funds, the proportion of the taxable components is much higher than the tax-free amount. In many cases, there may be no tax-free component at all.

The trick is to get as much money in as a non-concessional contribution, which ultimately ends up being tax-free.

An example . . .

Let’s say your entire superannuation fund is $500,000 and is made up of the taxable component only. If you leave it to your kids directly, the 15 per cent “death tax” kicks in, along with a 2 per cent Medicare levy when it’s paid to them.

The total amount deducted is a whopping $85,000. Had the super been paid to the estate, the tax would have been a reduced $75,000.

We’re going to make use of the non-concessional contribution limit, which this financial year is $120,000.

The $120,000 is withdrawn from super as a lump sum. You can generally only do this if you’re over 60 which, thanks to the other rule, means you pay no tax on the withdrawal.

The $120,000 is immediately paid back into the super fund as a non-concessional contribution.

You now have the same balance you started with, but with $120,000 now a tax-free component.

The next trick occurs in the new financial year. Super fund contribution cap indexation means the non-concessional cap rises by $10,000 to $130,000 on July 1.

Using another rule, you can bring forward three years worth of non-concessional contributions, so the maximum possible amount that can be paid into super from that date is $390,000 (that’s three lots of $130,000).

You do the same thing again, except this time you withdraw $390,000 and recontribute that amount. You can only do this if you haven’t already triggered the bring-forward rule in the past three years.

In effect, we’re maxing out the superannuation system and the rules over a three-month period.

Because of your earlier contribution, there are already tax-free funds which will be part of the $390,000 withdrawal. You can’t select the specific components, it must be apportioned based on the proportions in the total fund.

The $390,000 withdrawal in this case would include $93,600 of tax-free component with the remaining $296,400 being taxable money.

Again, it’s recontributed back into the super fund.

Our total tax-free component is now an impressive $416,400 leaving just $83,600 as a taxable component. Of course, this changes daily as the fund balance changes.

This example based on $500,000 has reduced the “super death tax” by at least a whopping $62,460, and $70,788 if paid to individuals.

Obviously, the more you have in super, the more tax is saved.

You can do it again

Better still, if you’re a bit younger, there’s nothing to stop you doing it again in three years’ time when the non-concessional contribution cap is reset. In fact, you can do it all the way up until your 75th birthday.

It is a bit convoluted but most large super funds see this done every day.

Some better funds now even streamline the process where it’s all done by them in one hit. You don’t even need to manually take money out and put it back in, the fund will do it for you.

Nick Bruining is an independent financial adviser and a member of the Certified Independent Financial Advisers Association