In Chloe Ward’s article from November 2014 – Creating a super legacy – we introduced a not so simple, but extremely valuable strategy known as the anti-detriment strategy. In this article we will explore the strategy in more detail, with a practical example of course, to show just how valuable an anti-detriment strategy can be for the right family.
WARNING: This article contains some technical taxation and superannuation concepts!
An anti-detriment strategy involves the payment of an additional amount to beneficiaries on the death of an SMSF member over and above the balance of that members account within the fund.
The additional amount payable can be calculated in two ways:
- Audit method
- Formula method
The audit method is preferred by the ATO, however it is difficult as it requires the trustees (or more likely their advisers) to track every dollar of contributions tax paid by the member across their lifetime – including not just from the SMSF, but from any superannuation fund accounts they may have rolled over to the SMSF. Obviously determine the amount via the audit method is very challenging, so the super laws enable you to apply a formula method as an alternative. For the sake of simplicity the formula method will be used in this example.
Calculating the anti-detriment amount
Consider Simon who passes away and has nominated his only daughter Michelle to receive his superannuation benefits. Simon’s balance in the SMSF at the time of his death are as follows:
Taxable component: $650,000
Tax free component: $550,000
Total benefits: $1,200,000
The anti-detriment amount calculated for Simon is as follows:
The above was calculated using our Anti-detriment calculator which is available on the Superfund Partners website here: Anti Detriment Death Benefit Calculator
The amount calculated for Simon is $93,841. If this amount is paid to Michelle in addition to the $1.2m balance of his member account within the SMSF, the fund will be eligible to claim a tax deduction of $625,605 in that financial year. This tax deduction is the true value of the strategy because that tax deduction will carry forward indefinitely as a tax loss for the SMSF, so if Michelle becomes a member of the SMSF, she can access that tax loss to offset the taxable income from her taxable super contributions and earnings.
To put it another way, by implementing the strategy Simon has utilised the tax regulations to legitimately create an additional asset of the fund valued at $93,841 (which is the dollar value of the $625,605 tax deduction the SMSF claims).
Still with me? Let’s now look at the taxation implications around the payment.
With any death benefit payment, tax is paid on the taxable portion by the (non-financial dependent) beneficiaries (assume adult children like Michelle) at 16.5%. The anti-detriment amount is considered a taxable component for the purpose of death benefits.
Assuming the same proportions, if the anti-detriment strategy was NOT used for Simon, the tax payable on the death benefit to Michelle would be as follows:
- $1,293,841 (total benefit) x 54% (taxable portion) x 16.5% = $115,367 tax
By comparison, when the anti-detriment strategy is used, the split of the components changes slightly, and results in the following tax:
- $1,200,000 (benefit from Simon’s account) x 54% (taxable portion) x 16.5% = $107,250 tax and
- $93,841 (anti-detriment amount) x 100% (taxable portion) x 16.5% = $15,484 tax
Combining the amount the total tax payable on the death benefit received by Michelle would be $122,734
This tax is withheld by the SMSF and paid to the ATO when the death benefits are paid. This means that the strategy results in additional tax withheld by the SMSF on the death benefit of $7,367
Paying the additional amount
As mentioned earlier in this article, the anti-detriment is paid over and above the balance of the members account. The amount however is required to ‘pass thought’ the account of the member when it is paid out the beneficiary – so in this case the $93,841 will be transferred from a reserve account into Simon’s member account and then paid to Michelle (less tax) as the beneficiary. The anti-detriment payment can only be paid once – so there is no ability to drip-feed it over multiple years.
When the allocation of the $93,841 occurs, it is counted towards Simon’s concessional contribution cap. Assuming Simon is over age 50 when he dies, the concessional contribution cap is $35,000, meaning $58,841 will be accessed as excess contributions and added to Simon’s personal income for that year. Assuming Simon doesn’t have other taxable income in that financial year, the tax payable on the excess contributions tax will be approximately $10,670.
It’s also worth noting that the concessional contribution cap is likely to increase in the future as it is indexed, and also that the tax-free threshold (currently $18,200) also applies – meaning smaller anti-detriment payments of $53,200 or less (where the deceased person has no other taxable income that year) will not incur any excess contributions tax.
So although we’ve created an additional asset of the SMSF to the value of $93,841, some additional tax has been created – i.e. the additional tax of $7,367 on the death benefit and $10,670 from the excess contributions tax resulting from the allocation of the anti-detriment amount. This reduces the dollar value benefit to Michelle as it reduces what she receives as Simon’s beneficiary. Michelle is still well ahead however – to the value of $75,804.
An anti-detriment payment must either be funded from insurance proceeds, or a reserve within the SMSF. As most people who implement this strategy have significant balances within their SMSFs, it is most likely that a reserve will be utilised rather than insurance proceeds.
So what is a reserve?
In the context of an SMSF a reserve is simply an amount within the fund which is NOT allocated to a particular member.
Continuing with Simon’s SMSF as an example, the make up of the fund is as follows:
The amount that forms the reserve will typically be populated from an allocation from investment earnings over a number of years. It cannot be formed by directly reducing the balances of existing members of the SMSF. This means that the strategy to establish the reserve for the purposes of the future payment of an anti-detriment amount needs to be implemented many years in advance to ensure there are sufficient funds available at the time the payment is required (i.e. when the member of the SMSF dies).
A reserve also requires it’s own investment strategy separate from the investment strategy of the SMSF as a whole, and in most cases the best way to ‘construct’ the reserve is through the establishment of an additional bank account and investment accounts in the name of the SMSF which are segregated for accounting and taxation purposes. This means that the reserve is almost like a ‘fund within a fund’.
Assuming the members of the SMSF are receiving pensions, a tax exemption is available on any income / gains generated on the assets supporting their pension accounts. With assets held in a reserve within an SMSF, this tax exemption doesn’t apply. For this reason it is essential that advice is sought on the most appropriate investments to be utilised for the reserve account.
Most of the clients we work with have a combination of growth and income orientated investments, so in simple terms it makes sense to have growth orientated assets held as part of the reserve investment strategy, and have the income generating assets as part of the tax exempt investments supporting the pensions. The application of the anti-detriment / reserving strategy in this way means that the SMSF can effectively maintain a 100% (or close to) tax exemption on all earnings and gains.
As the balance of the investments of the SMSF change, the value of the anti-detriment amount set aside in the reserve will also change. This means that at least once every year (typically when the accounts are completed) an adjustment will need to be made to either allocate either additional profits to the reserve, or to make an allocation from the reserve back to the members accounts. In situations when amounts are moved from the reserve back to the member accounts, those amounts will not count against the members contribution cap if they amount is less than 5% of the members balance and the allocation is an even percentage across all members of the fund.
Cost versus benefit
As with other financial decisions, you always need to consider the benefits received from the strategy versus the cost of implementation.
With the example of Simon and his daughter Michelle, we’ve utilised the anti-detriment strategy to generate an asset within the fund valued at $93,841. In doing so, based on a few assumptions, we know that there will be additional death benefits tax as well as some excess contributions tax on Simon’s death.
There will also be professional costs to implement, maintain and action the strategy over a number of years, and although the strategy is complex (therefore cost more in fees) the benefit gained will significantly outweigh the costs.
Probably the most important thing to consider however is the huge value created by ‘passing the torch’ of a family SMSF to the next generation. All the trustees we work with absolutely love the positive impact their SMSF has had on their financial lives, and they want their children to enjoy the same benefits. This strategy enables those benefits to be turbo-charged via a huge carry-forward tax loss the next generation can use.
The bigger picture
What we have found when implementing an anti-detriment strategy with our clients is that it forces a number of other questions to be addressed including:
- Who do I want my super benefits to be passed onto when I die?
- Will the right person / people be in control of my SMSF when I pass away or it I loose capacity?
- How does my personal Will impact on my SMSF and control of my SMSF assets?
- Should my children be in my SMSF or in there own SMSF?
- Is my current investment strategy appropriate?
- Does my trustee deed allow for an anti-detriment payment to be made?
- Should my SMSF have a corporate trustee? (the answer to this questions is always YES!)
The great thing about going through this process is that it forces you as trustees of your SMSF to ensure you have a comprehensive and robust estate plan – which in itself creates a significant amount of certainty and security.
Is an anti-detriment strategy for you?
As we explored in our previous article (Creating a super legacy) an anti-detriment strategy is not for everyone. From our perspective you would typically have to meet most, if not all, of the following criteria before we would recommend the strategy:
- You have a family, typically adult children who are financial astute and who would understand the valuable financial gift they would be receiving (i.e. an SMSF with a sizable tax deduction that would carry forward)
- A total SMSF balance that is above average in size. The average SMSF balance is $929,000 (June 2012 statistics)
- The dollar value benefit in terms of tax savings you can pass on is significant
- You are willing to put in place a comprehensive estate plan in place if you haven’t already done so
- You have the ability to weigh up the cost versus the benefit of the strategy to determine whether it is appropriate for your family
- You are willing to be educated on the mechanics of how the strategy works, as well ensure your family understands enough to be able to fully utilise the strategy when you pass away
If you are interested in exploring the option of an anti-detriment strategy, then please get in contact to discuss it with myself or Chloe Ward.
Phone: 1300 889 282