The challenge of who will inherit your super

People don't like to think about death or how their family would cope without them or, for that matter, the need for life insurance.

Fortunately, super fund members older than 25 are automatically given a basic amount of default life cover. But here's the rub: it's up to the fund member to actively nominate who their beneficiaries are.

Superannuation isn't automatically part of your estate under Australian law. If you don't have a valid binding nomination in place, your super fund's trustee can decide how your death benefit - super plus insurance payout - should be distributed.

Generally, super can only be paid to a dependant or your legal personal representative (LPR) (the executor of your estate). Under super law a dependant is defined as a spouse or de facto spouse, your children and stepchildren, or someone you're in an interdependent relationship with. This means you can't nominate a friend or other relative.

If you want to leave your death benefit to someone who isn't a dependant, you need to make a binding nomination to have it paid to your LPR where it will be distributed, according to your will.

How binding and non-binding nominations work

If you make a non-binding nomination, the trustee will consider your nomination but it isn't legally binding.

If you have a valid binding death nomination in place on your account at time of death, the trustee is required by law to pay your nominated beneficiaries.

"It's not binding unless two people witness and sign it. If it's just a nomination, the trustee has the discretion whether to honour it or not," says Marisa Broome, a certified financial planner and principal of wealthadvice.com.au.

Your super fund should be able to help you find the relevant form. Once completed, you will need to have it witnessed and signed by two people.

When you make a binding nomination, you need to decide whether it should be a lapsing or non-lapsing nomination.

Why you should nominate a legal personal representative

Risk specialist, Sam Perera, director of Perera Crowther Financial Services, says superannuation fund trustees have a legal obligation to determine who is a dependant and how benefits should be paid.

"This can lead to delays or outcomes that differ from your informal wishes. By directing the funds to your legal personal representative (LPR), you remove this element of discretion, ensuring your specific instructions are followed."

He says there are two main reasons to nominate an LPR.

"You do not have a beneficiary who is a dependant, so you have no option but to nominate your LPR. Many younger Australians fall into this cohort as they may not have a spouse or children or anyone who 
is financially dependent on them or they may be in an interdependent relationship.

"In this instance you can have your death benefit paid to your estate where you can nominate friends and/or family members in your will to receive your fund bypassing the need for the money to be paid to a dependant.

Second, you have more complex estate-planning wishes, such as establishing a testamentary trust, and want your super benefits to form part of it.

"There are tax advantages of setting up a testamentary trust, which may be a significant driver of this strategy.

"If you have beneficiaries with disabilities or special needs who rely on government benefits, a direct inheritance could impact their eligibility. Through nominating your LPR and setting up a special disability trust in your will, you may be able to provide for their care without jeopardising their entitlements.

"Blended families may also require flexibility with estate planning to provide for stepchildren or ex-spouses, and having your death benefit paid to your estate could offer greater flexibility in this regard."

He says when a super death benefit is paid to a non-dependant beneficiary, it is still subject to tax. "Having the funds flow through your estate does not eliminate this tax liability for non-dependants.

"The Australian Taxation Office views a super death benefit as retaining its character even when paid to an estate. When a super death benefit is paid to a non-dependant, the taxable component of the benefit is subject to a tax rate of 15% plus the Medicare Levy (currently 2%), for a total of 17% and could be even higher."

Perera points out that a will can be contested. "Nominating your LPR as the beneficiary of super death benefit exposes those benefits to potential challenges within the will.  In contrast, a valid binding death benefit nomination directed to a dependant bypasses the estate and cannot be challenged via the will."

He recommends seeking financial advice. For instance, if you are diagnosed with a terminal illness, you may be able to access your entire super balance as a tax-free lump sum.

"Cashing your benefit may not always be the best option, but a good financial plan will consider the tax treatment and your estate-planning wishes in formulating a recommendation.

A lapsing nomination expires after three years and you need to reconfirm it before it lapses. A non-lapsing nomination is permanent unless you revoke it. You can revoke or change your nominations at any time. "If it's a binding nomination, the trustees are bound to follow that through unless there is a legal challenge to it. People don't do a binding nomination because they're unengaged," she says.

Often, people kid themselves that they will attend to it later. "Disengagement has consequences. Many people think their super is automatically dealt with by their estate but that's not the case," says Broome.

How super is taxed

In the event of your death, your benefit will be tax free in the hands of your dependants, such as your spouse and dependent children, including those older than 18 who are still financially dependent on the deceased.

"You can nominate anyone if there is a legitimate relationship or a legitimate tie, but if it's a non-dependant, and they inherit your super, they'll pay tax on that inheritance. If it goes to a spouse or disabled child or child under the age of 25 that can prove dependency, then they don't pay tax," says Broome.

"If your super goes to your adult children, they will be taxed. Take a couple, one dies leaving the other their super, the remaining spouse then dies, leaving the super to their adult children who are in their 40s. They would pay 17 cents in the dollar tax because they are no longer dependants."

When a client dies, Broome says she considers the health of their spouse and if its fragile, weighs up whether super is still the right vehicle for them. "If the surviving spouse is in poor health, it might be worth pulling all the money out of super, even though there's no tax on income there.

"Outside of super they'll be paying minimal tax and adult children won't have to pay the 17 cents in the dollar super tax."

Broome says super fund members generally don't pay enough attention to death benefit nominations or their life cover.

"Most Australians don't actively seek life insurance and are dreadfully underinsured, and it's a vital thing to have."

Remember, default cover is fairly basic, so you need to check whether the sum insured is enough to pay off your mortgage and support your family in the event of death.

If the amount isn't sufficient, you should consider increasing the sum insured.

Similarly, older fund members who have paid off the mortgage, have other assets outside of super and no dependent children, should consider whether their cover is still necessary as the premiums could be considerable.

Finally, consider contacting your fund for help or seeking professional advice as there may be a lot at stake.

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