Most people now have the bulk of their life insurance through their superannuation fund.
It's a highly cost-effective way to buy life insurance, but there can be huge implications along the way if good estate planning is not put in place at the outset.
The problem is the tax on the proceeds of the insurance policy if it is left to a non-dependent.
A good example is a young single with $300,000 of death cover through their work super fund. They are unlikely to have tax dependants, so if they were killed in an accident the tax office would take nearly $100,000, leaving just $200,000 in their estate.
Life insurance proceeds held within superannuation suffer a much higher tax than ordinary superannuation benefits because they are treated as "untaxed" and are subject to 30 per cent tax (excluding Medicare levy) when paid to a non-dependant.
Now consider what may happen if the estate does not have the money to pay the tax.
Think about Jim, a single father aged 50 with three adult children who all work - his youngest lives at home with him. Jim's house was worth $380,000 in 2008 when his will was drafted. He has $300,000 in super fund A, and just $15,000 in super fund B. There is also a $300,000 insurance policy in super fund B - this is the fund that is paying the premiums, because it has the smallest balance.
Jim wanted his will to treat his children equally. Therefore, it was drafted to give the first child the proceeds of Fund A, the second child the proceeds of Fund B and the residue of his estate to the third child, who was living at home. Jim figured that would be the house and contents.
The children knew that their father had left them equal shares of his estate. But when Jim died unexpectedly they got a terrible shock when they discovered they were not going to be treated equally at all.
Jim had thought that his first child would receive around $255,000, as the proceeds from Fund A would be taxed at 15 per cent, while the proceeds of the insurance policy held by Fund B would yield about $215,000 for his middle child, after the tax of approximately $100,000 was deducted.
Problem 1: super funds do not deduct the death tax and send the balance to the estate. Rather, they send the entire amount to the estate - it is the estate that has the obligation to send the death tax to the ATO.
Problem 2: because the will specifically gave "the proceeds of Fund A" to the first child and "the proceeds of Fund B" to the second child, they are entitled to the whole of $300,000 and $315,000 respectively. The tax still has to be paid - but it doesn't come out of the proceeds received from either super fund.
The executor of the estate is responsible for paying $145,000 to the tax office ($45,000 on Fund A and approximately $100,000 on Fund B).
Because children one and two have received specific bequests, the tax can only be paid out of the residue of the estate. Using a concept known as "marshalling", the executor will probably have to sell the home to pay the $145,000 tax bill.
Not only has the third child borne the cost of the tax payable on both of the superannuation payouts, but also the family home has been lost to pay the tax bill.
It is critical that anyone drafting a will understands that all assets are not treated equally for tax purposes.
As the above example shows, failure to take death taxes properly into account can have disastrous and unforeseen consequences.
- Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance. firstname.lastname@example.org