The old saying used to be that there's nothing certain about life than death and taxes, and things get really interesting and somewhat complex when you combine the two in the form of death taxes.
It is true that Australia doesn't have specific death taxes such as those that operate in the US in the UK but in practise inheriting money can sometimes come with a big tax bill, depending on the specific assets involved and the amount of financial planning that has occurred.
In effect, Australia does have several death taxes, it is just that they are disguised in the form of other taxes with an important caveat that some of them can be avoided entirely with the right planning.
How to Delete Hidden Death Taxes
The most important bit of financial planning revolves around superannuation accounts.
In the case of a couple where one spouse dies, this superannuation account usually passes seamlessly to their spouse with no taxation at all, provided that the death benefit notification has been made correctly.
Things get very interesting though, when the remaining spouse dies and their superannuation is left to non-dependent children, with a tax bill that can vary anywhere from zero all the way up to 17% – made up of 15% plus the Medicare levy.
That dramatic difference in tax treatment comes about because all superannuation balances are divided into two separate piles – a taxable component and a tax-free component.
Your super fund can tell you how much you have in each component or may show it on your statements but usually the taxable component is the highest, being made up of compulsory employer contributions, salary sacrifice and tax-deductible contributions.
So how do you go about avoiding this hefty tax?
Withdrawal and Recontribution?
There are two main methods, both of them simple in concept but they are often ignored or neglected due to the actual or perceived difficulty involved.
The first method is known as a ‘withdrawal and re-contribution’ strategy.
This involves withdrawing some money from your super every year and then re-contributing it back into super, effectively reducing the taxable component and increasing the tax-free component.
Over time, the potential death tax is reduced or brought down to zero but there are some limitations and complications to be aware of.
This is also a fairly complex strategy which may require professional advice to get right.
Things to be aware of include the conditions of release having been met (either retirement of reaching the age of 65), the contribution caps which apply to recontributions which mean it may take many years to fully achieve tax free status and also complications around having to make contributions to a separate accrual fund rather than your pension account.
There is also an opportunity cost in selling down super assets and moving back into an accrual account before moving back to pension mode.
Or Total Withdrawal?
The other strategy is to fully withdraw all of the money out of your superannuation account before you die - something that is easier said than done.
Death may come for all of us but sometimes it can be sudden and unexpected and other times it might come much later than was initially expected.
It can also take some time for super funds to process withdrawals, meaning that a tax saving may not be achieved in time.
As you can see, both methods of avoiding the superannuation death tax are problematic.
One is slow and complex and may require professional help while the other method relies to some extent on working out the timing of someone's death.
Nevertheless, this is a substantial amount of tax that can be reduce to zero so it is definitely preferable to avoid if possible.
Capital Gains Tax is Always Lurking
There are several other taxes which act on inheritances and serve as de facto death taxes.
Capital gains tax (CGT) he's one of those and while death does not trigger CGT, it remains a liability for the beneficiaries.
Those beneficiaries will pay CGT on the basis of the deceased's cost base when they dispose of the asset.
Given the amount of inheritance impatience that now exists due to generational inequality and desperation to get into the property market, that disposal may happen fairly quickly after death.
The hidden sting in the tail here is that capital losses die with their owner, meaning that there is no opportunity to offset the capital gains that apply when selling an asset.
Clock Ticking on the Family Home
One peculiarity here is the family home.
As long as it was a primary residence, it can usually be sold within two years with no capital gains tax payable.
However, that situation may get more complex if the home is leased in the interim and generates rental income or if it is held for more than two years.
In the case of shares, an investment property or other investments, CGT can represent a sizable tax impost when the assets are sold because CGT is calculated on the difference between the sale price and the price at acquisition.
In the case of Commonwealth Bank shares bought at the float for just $5.40, a sale at the current price of around $170 a share is going to generate one heck of a CGT liability when sold.
Strangely, while investing money for growth during a lifetime is far superior to the cash alternative, upon death the best asset for tax purposes is good old cash in the bank.
Cash has no attached taxes when inherited, although there is obviously CGT to be paid by the person who sells assets before they die.
The other caveat is that any interest earned on cash is obviously taxable through income tax at the rate applying to the individual owner.
Hang on?
The other option for inherited assets – financial or property – is to simply hang on to them, in which case the taxes payable remain a hidden liability rather than a current reality.
That locks in the investment choices made by the deceased person which may be a far cry from the choices that the inheriting person would make but it can be a viable strategy to indefinitely postpone the effective death taxes.
As you can see, the intersection between death and taxes is a very complex one.
It is also a great example of where being organised with your estate planning can save bucketloads of tax for your surviving beneficiaries, even if those taxes are not specifically labelled as “death taxes” in Australia.
