For retired couples with substantial superannuation balances, the interaction between reversionary pensions, Division 296 tax and estate planning can become increasingly important.
A common concern is whether reversionary pensions should be cancelled or altered where each spouse’s superannuation balance is approaching the $3 million Division 296 threshold.
In many cases, changing the reversionary pension itself may not reduce exposure to Division 296. Instead, the more important planning considerations are the balance held by each individual, the timing of a death benefit, the taxable and tax-free components of each account, and how the surviving spouse ultimately restructures or withdraws superannuation.
Division 296 Is Assessed Individually
Division 296 is designed to apply an additional 15 per cent tax to a proportion of superannuation earnings where an individual’s total super balance exceeds $3 million.
Importantly, the threshold applies to each person individually rather than to a couple as a household.
This means that a couple could collectively hold close to $6 million in superannuation without necessarily being subject to Division 296, provided neither individual exceeds the applicable threshold.
For example, if one spouse has $2.8 million and the other has $2.9 million, neither is currently above the $3 million threshold.
The relevant issue may arise later if investment growth pushes one account above the threshold, or following the death of one spouse when a reversionary pension transfers to the surviving spouse.
What Happens When a Reversionary Pension Passes to a Spouse?
A reversionary pension is structured so that, when the pension recipient dies, the pension automatically continues to an eligible beneficiary, commonly their spouse.
This can provide significant administrative and estate planning benefits because the income stream does not simply stop on death and require a completely new pension to be established.
Where both spouses hold large superannuation balances, however, the surviving spouse could temporarily end up with a substantially larger total super balance.
Consider a couple holding approximately $2.8 million and $2.9 million respectively.
After the death of the first spouse, the survivor could effectively have approximately $5.7 million associated with their superannuation interests.
This creates two separate issues that need to be managed:
- the transfer balance cap rules; and
- potential Division 296 exposure.
The 12-Month Reversionary Pension Grace Period
One of the important benefits of a reversionary pension is the timing concession available under the transfer balance cap rules.
Where a pension automatically reverts to a surviving spouse, the value of the deceased spouse’s pension generally does not count towards the survivor’s transfer balance account immediately.
Instead, there is broadly a 12-month period before the credit arises.
This gives the surviving spouse time to review their circumstances and determine how best to restructure their superannuation.
Depending on the circumstances, they may decide to:
- retain the inherited pension;
- move some of their own pension back into accumulation;
- withdraw part of their own superannuation;
- withdraw some or all of the inherited amount where permitted; or
- restructure their overall retirement income strategy.
This additional year can provide valuable planning flexibility.
Removing the reversionary pension may therefore mean giving up an important timing concession without necessarily achieving any saving under Division 296.
Division 296 Does Not Provide the Same Grace Period
Division 296 operates differently.
The surviving spouse’s total super balance can increase after receiving the deceased spouse’s superannuation interest, and the Division 296 calculation is based on the individual’s balance at the relevant 30 June.
The 12-month transfer balance cap concession does not necessarily defer the Division 296 calculation in the same way.
As a result, a surviving spouse who temporarily has a large amount within the superannuation system could potentially be exposed to Division 296, even while they are still within the period available to restructure their retirement-phase pensions.
An Example of the Potential Division 296 Impact
Assume a surviving spouse ends up with approximately $5.7 million in superannuation following their partner’s death.
If the combined superannuation balance generated realised earnings of approximately 5 per cent, this would equate to around $285,000 of earnings.
Approximately 47 per cent of the $5.7 million balance would sit above a $3 million threshold.
On a simplified basis, around $135,000 of the earnings could therefore relate to the portion above the threshold.
Applying an additional 15 per cent tax would produce an approximate Division 296 liability of around $20,000 for that year.
While this is a meaningful amount, it needs to be considered in the context of a $5.7 million superannuation balance.
The tax may also only apply while the survivor’s balance remains above the relevant threshold.
Cancelling a Reversionary Pension May Not Reduce Division 296
One of the key planning points is that Division 296 generally focuses on how much an individual has within the superannuation system, rather than whether the money arrived through a reversionary pension or another death-benefit process.
If a reversionary nomination is cancelled and the surviving spouse still receives the deceased spouse’s superannuation and keeps it within super, their overall balance may ultimately be similar.
The Division 296 position may therefore also be similar.
In other words, cancelling a reversionary pension may change the administrative process without necessarily changing the underlying Division 296 exposure.
The main way for the surviving spouse to reduce their total super balance may be to withdraw money from the superannuation environment.
A surviving spouse may have the ability to commute some or all of the inherited pension and receive the benefit as a lump sum, subject to the applicable superannuation and fund rules.
For a spouse, superannuation death benefits can generally be received tax-free.
This gives the survivor flexibility to decide whether retaining all the inherited money inside super remains appropriate.
The Tax-Free and Taxable Components Still Matter
Another important consideration is the composition of each spouse’s superannuation account.
Superannuation benefits are generally made up of:
- a tax-free component; and
- a taxable component.
Once a pension commences, the proportion of the pension that is tax-free and taxable is generally fixed.
For example, one spouse may have a pension that is 60 per cent tax-free, while the other spouse’s pension may only be 20 per cent tax-free.
Those percentages can become important when planning for the eventual transfer of wealth to adult children.
The Superannuation Death Benefits Tax Issue
Where superannuation passes to a spouse, the benefit is generally received tax-free.
However, when superannuation is eventually paid to adult, financially independent children, the taxable component may be subject to death benefits tax.
The tax-free component is generally not subject to this tax.
This means that an account with a higher tax-free component may be more valuable from an estate planning perspective.
For example, an account that is 60 per cent tax-free potentially exposes a much smaller portion of the remaining benefit to death benefits tax than an account that is only 20 per cent tax-free.
For families with several million dollars remaining in superannuation, this distinction can produce a substantial difference in the amount ultimately received by beneficiaries.
Keeping Only One Reversionary Pension May Not Solve the Problem
It may initially appear logical to retain the reversionary pension with the larger tax-free component and cancel the other one.
However, this does not necessarily achieve the desired outcome.
A reversionary nomination determines what happens if that particular pension recipient dies first.
It does not alter the tax-free and taxable components of the underlying account.
It also does not allow a couple to determine which spouse will die first.
As a result, keeping only one reversionary pension may simply remove the protections associated with the other pension without providing a clear tax advantage.
Where both pensions remain appropriate and valid, retaining both may preserve greater flexibility regardless of which spouse dies first.
Consider Which Account Funds Additional Spending
The different tax-free percentages can nevertheless be used as part of a broader estate planning strategy.
One possible approach is to preserve the pension with the larger tax-free component and draw more heavily from the pension with the larger taxable component.
After age 60, pension payments and eligible lump-sum withdrawals are generally tax-free to the member.
This means a retiree may be able to:
- draw only the required minimum pension from the account with the higher tax-free percentage; and
- fund additional living expenses or discretionary lump-sum withdrawals from the account with the higher taxable component.
Over time, this can gradually reduce the amount of taxable component remaining inside superannuation.
Every dollar withdrawn from an account with a high taxable component is a dollar that may no longer be exposed to death benefits tax if the eventual beneficiaries are adult, financially independent children.
This can make the order in which superannuation accounts are drawn down an important part of estate planning.
Superannuation Strategy Should Be Reviewed Regularly
For retirees with balances approaching the Division 296 threshold, superannuation strategy should not be treated as static.
A review should consider:
- each spouse’s total super balance;
- expected investment returns;
- minimum pension withdrawals;
- the indexed Division 296 threshold;
- taxable and tax-free components;
- transfer balance cap implications;
- reversionary pension arrangements;
- binding death benefit nominations;
- likely beneficiaries;
- expected retirement spending;
- assets held outside superannuation; and
- the potential tax consequences when wealth ultimately passes to the next generation.
The best strategy may change as balances grow or decline, legislation changes, or family circumstances evolve.
Check the Rules of Your Superannuation Fund
Not all superannuation funds administer death benefits and pensions in exactly the same way.
Retirees with longstanding reversionary pensions should confirm that their existing nominations remain valid and understand what their fund allows following the death of a member.
Important questions may include:
- Is the pension genuinely reversionary?
- Is the reversionary nomination still valid?
- Can the surviving spouse partially commute the inherited pension?
- Can the survivor take some or all of the benefit as a lump sum?
- Can the survivor retain the pension while restructuring their own superannuation?
- What administrative process applies following death?
- What happens if the existing reversionary nomination is cancelled?
These details should be understood before making any changes.
The Broader Financial Planning Opportunity
For couples with substantial retirement savings, the objective should not simply be to avoid one particular tax.
The strategy should consider the combined effect of Division 296, transfer balance cap rules, death benefits tax, retirement income requirements and estate planning.
In some circumstances, temporarily paying Division 296 may be preferable to unnecessarily withdrawing money from a tax-effective superannuation environment.
In others, gradually reducing taxable superannuation balances may help manage both Division 296 exposure and future death benefits tax.
The appropriate strategy will depend on the couple’s age, spending requirements, investment objectives, other assets and intended beneficiaries.
The important point is that reversionary pensions should not generally be cancelled solely because a couple is concerned about Division 296. Any change should first be assessed against the valuable succession and transfer balance cap benefits that may be lost.
For families approaching the $3 million Division 296 threshold, forward planning can provide significantly more flexibility than waiting until the death of one spouse forces decisions to be made quickly.
Contact Cadre Capital Partners if you would like assistance reviewing your reversionary pension arrangements, Division 296 exposure, retirement income strategy and the tax implications of passing your superannuation to the next generation.
Important Information
This article contains general information only and does not take into account your personal objectives, financial situation or needs. Superannuation, taxation and estate planning rules are complex and subject to change. Before acting on any information, you should consider its appropriateness to your circumstances and obtain relevant financial, taxation and legal advice.