In Australia, we don’t currently have an inheritance tax like some other countries do. That said, the idea has been popping up in political conversations, especially with the government recently discussing it at the Economic Reform Summit in August.
But here’s the thing: while we don’t have a broad inheritance tax, there is one sneaky tax that often catches people out – the superannuation death benefit tax.
Why does this tax exist?
The superannuation system is designed primarily to help Australians save for their own retirement, not necessarily to pass wealth onto the next generation. Concessional (tax-deductible) contributions, like employer super guarantee payments and salary-sacrificed amounts, are taxed at just 15% when they go into super, or 30% for individuals with adjusted taxable income of more than $250,000. That’s far less than most people’s marginal tax rate.
The government introduced the death benefit tax to “claw back” some of these concessions if super is ultimately passed down as an inheritance, rather than used for retirement. In simple terms: if your kids inherit your super, the ATO takes a slice on the way through.
How does it work?
Under super rules, the “taxable component” of your superannuation balance is taxed at 17% when it’s paid as a death benefit to a “non-dependant.”
The taxable component is basically the part of your super made up of concessional contributions and earnings on those contributions – think employer contributions and salary-sacrificed amounts. Your annual super statement will set out your super balance taxable and tax-free components.
Who counts as a “non-dependant”? Anyone who isn’t:
- a spouse (current or former);
- a child under 18;
- someone you have an interdependency relationship with; or
- someone financially dependent on you.
For most people, their super is made up mostly of concessional contributions, which means a big chunk of their balance sits in the taxable component.
When one spouse dies, the other can usually inherit the super tax-free because they are a dependant. But when the surviving spouse eventually passes away, the super often goes to adult children, who are considered non-dependants. And that’s where the 17% tax kicks in, potentially eroding hundreds of thousands of dollars from the inheritance.
The traditional recontribution strategy
A common way to reduce the super death benefit tax is through what’s called a recontribution strategy.
Here’s how it works:
- Once you retire at 60 (or hit age 65 regardless of work status), you can access your super.
- You withdraw money from your fund (tax-free at that age).
- You then recontribute the money back in as a non-concessional contribution, turning what was once a taxable component into tax-free component.
Currently, the non-concessional contribution cap is $120,000 per person per year. With the “bring-forward rule,” you can contribute up to $360,000 in one year, if your balance is less than $1.76 million at the beginning of the financial year.
This does help, but it has a limitation. You can’t choose to only withdraw taxable components – you must withdraw in proportion to your super’s taxable and tax-free split. So, each time you recontribute, the effectiveness drops if you recontribute into your existing super account.
A numerical example
Let’s say:
- You start with $1,000,000 in super, all taxable.
- You recontribute $360,000. Your balance is now 36% tax-free and 64% taxable.
- After two years, you do the same again. Now your balance is 41% tax-free and 59% taxable.
- Do it again, and the percentage gain each time gets smaller.
In fact, it would take 27 years of repeating this process to fully convert your balance to tax-free. That’s well beyond the 15-year window (between age 60 and 75) that most people have available.
So, while the strategy works in theory, it’s not practical for most retirees.
A smarter recontribution strategy
A far more effective variation is to use two super accounts, which could be with the same fund or different funds – doesn’t matter.
Why? Because the taxable/tax-free split is measured at the account level, not across all of your super. That means you can keep taxable and tax-free components separate.
Using the same $1,000,000 example:
- You set up a second super account.
- Contribute $360,000 into the second/new account. Now, across both funds, you still have 36% tax-free, 64% taxable.
- But here’s the difference: in future years, you withdraw only from the taxable fund and recontribute into the tax-free fund.
By isolating components like this, you don’t dilute the mix each time you withdraw and recontribute.
Repeat this every couple of years, and in around 9 years, you can convert the entire balance to tax-free – completely wiping out the potential death benefit tax. That’s a saving of around $170,000 in this example.
What about costs?
Yes, running two super funds comes with a small extra cost, but it’s usually minimal.
Most funds charge a percentage-based administration fee (which doesn’t change if you open a second account) plus a flat account-keeping fee. Typically:
- AustralianSuper: $52 p.a.
- UniSuper: $96 p.a.
- Netwealth or Hub24: $240 p.a.
Even at the higher end, paying $240 a year for less than a decade is a tiny price compared to saving $170,000+ in tax. Once your balance has been fully converted, you can close one fund and drop back to a single account.
Think of it this way: if you could pay a few hundred dollars a year to save your children six figures, would you do it? Most people would say “yes” without hesitation.
A real-life example
Let’s say someone retires at 60 with $1.8 million in super – all taxable. They have one adult child as their nominated beneficiary.
If they passed away immediately, the death benefit tax would be around $306,000, leaving just under $1.5 million to their child.
Instead, they use the two-fund recontribution strategy. They keep their existing account in accumulation phase (i.e., not convert to pension phase) and withdraw enough each year to cover living expenses ($100k) plus $120k to recontribute into the second fund. Alternatively, and more optimally, they can convert their existing super account to pension phase and convert $120k back into accumulation phase each year to withdraw as a lump sum. The benefit here is that the funds are invested tax-free in pension phase and the person does not run the risk of exceeding their lifetime Transfer Balance Cap. The second fund can be in pension phase and refreshed each year after a contribution is made. To minimise the administrative burden, it could also be easier to do this strategy every 3 years with $360k via the use of the “bring-forward rule”. This strategy has a reasonable amount of complexity, so it’s best to seek personalised advice.
With a 7% p.a. return, 2.5% p.a. inflation, and some expected increases to contribution caps, they could convert their entire balance within 11 years.
By then, they would have more than $2 million – all tax-free and all in pension phase. Their child would inherit the full amount, saving over $340,000 in death benefit tax.
The cost? Around $1,056 in account fees across those 11 years. A bargain compared to the tax saved.
Reversionary pensions
While this isn’t strictly about the super death tax, it’s worth highlighting that super pensions should generally be set up as reversionary pensions. A reversionary pension automatically transfers to your spouse when you pass away, allowing them to keep your super inside the tax‑free super system. If the pension isn’t reversionary, the super would instead need to be paid out to your spouse in their personal name, potentially losing some of the tax advantages.
Binding death benefit nominations
A few weeks ago, Stuart wrote a blog about testamentary trusts. If you want your beneficiaries to benefit from a testamentary trust, your surviving spouse needs to nominate your legal personal representative in your super binding death benefit nomination. This ensures that your super (ideally tax‑free) is paid into your estate and can then flow into the testamentary trust.
Final thoughts
They say the only certainties in life are death and taxes. But when it comes to the super death benefit tax, that’s not entirely true. With some smart planning, and a second super fund, you can make sure more of your wealth passes on to your loved ones, instead of the ATO.
Superannuation is one of the most tax-effective structures available during your lifetime. But without a strategy, it can become one of the least tax-effective when it passes to the next generation. That’s why it’s so important to plan ahead.
If you’re approaching retirement and want to protect your family’s inheritance, a smarter recontribution strategy is well worth considering. A little extra planning now can mean hundreds of thousands more for your loved ones later.
