3 Ways to Reduce the Hidden Tax on Your Superannuation

Did you know that a hidden "inheritance tax" on your superannuation could see the Australian Taxation Office (ATO) take up to 17% of your balance when it's passed on to your adult children? This often-overlooked tax can result in a significant loss of your hard-earned retirement savings.

This guide will break down how this tax works and share three powerful strategies you can use to reduce or even eliminate it, potentially saving your family tens of thousands of dollars.

How is Super Taxed After You Die?

When you pass away with a balance in your superannuation, that money is paid out as a super death benefit. This can go to your estate or directly to a dependant, such as a spouse, a child of any age, or a financial dependant.

However, the tax treatment of this payment depends on whether the beneficiary is considered a "tax dependant".

• Tax Dependant: Includes your spouse or de facto partner, a child under 18, or someone in a financial or interdependency relationship with you.
• Non-Tax Dependant: Most commonly, this is a financially independent adult child.

Superannuation death benefits paid to a tax dependant are completely tax-free. But it's a very different story when the beneficiary is a non-tax dependant.

Your super balance is made up of two components: a tax-free component (from after-tax contributions) and a taxable component (from pre-tax contributions and investment earnings). When paid to an adult child:

• The tax-free component remains tax-free.
• The taxable component is taxed at 15% plus the Medicare levy, bringing the total tax to 17%.

For example, if you have a $500,000 taxable component in your super, your adult child could lose $85,000 straight to tax.

Strategy 1: The Re-Contribution Strategy

This is one of the most effective ways to "clean" your super and reduce the future tax bill. It involves withdrawing money from your super and then re-contributing it as a non-concessional (after-tax) contribution.

Here’s how it works: Let's say Josh is 65 and retired with a $600,000 super balance:

• $100,000 is in the tax-free component.
• $500,000 is in the taxable component.

If Josh passed away, his adult son, Dave, would face an $85,000 tax bill on the taxable portion. Instead, Josh implements a re-contribution strategy:

1. Withdraw: Josh withdraws a lump sum from his super. Because he is retired and over 60, these withdrawals are tax-free to him.
2. Re-contribute: He then re-contributes that money back into his super as a non-concessional contribution. This contribution is added to his tax-free component.

By doing this, Josh can convert a large portion of his taxable component into a tax-free component. In his case, he could reduce the taxable portion from $500,000 down to just $100,000.

The result? The potential tax bill for his son drops from $85,000 to just $17,000 – a saving of $68,000.

Strategy 2: Have Super Paid Through Your Estate

Another effective strategy is to have your super death benefit paid to your estate first, rather than directly to your adult children. While this doesn't eliminate the tax, it can significantly reduce it and avoid other financial complications for your beneficiaries.

Here are the benefits:

• No Medicare Levy: When the payment goes through the estate, the 2% Medicare levy does not apply, reducing the tax rate from 17% to 15%.
• No Impact on Beneficiary's Income: The lump sum is not counted as assessable income in your child's personal tax return. This avoids a sudden spike in their income, which could otherwise trigger a Medicare levy surcharge, higher HECS repayments, or a loss of family tax benefits.

While this strategy can be very effective, it's important to weigh the pros and cons. Money paid through an estate might take longer to be distributed and could be exposed to disputes over the will.

Strategy 3: Cash Out Super Before Death

The simplest way to avoid the super death benefits tax is to withdraw the money from the super system entirely before you pass away. Once the money is out of super, it is no longer subject to this tax and simply becomes part of your estate.

The catch? Timing. This strategy comes with significant risks and complexities:

• Loss of Concessions: Taking money out of super too early means it loses all the tax protections and concessions of the super environment.
• Estate Planning Complications: It could lead to complications with Centrelink benefits and increase the risk of family disputes.

While cashing out super can wipe out the tax, it is a strategy that requires careful consideration and professional advice.