Using proceeds from a TPD benefit to begin a pension can be useful for several reasons, not least the ability to provide a client with a regular tax-effective source of income.

Much like the tax treatment of lump sums discussed last month, it’s only the taxable portion of a pension payment that may be subject to tax. The tax treatment of disability superannuation pension payments is summarised in the following table:

Age at the time a pension payment is received…	The taxable portion of pension payments received is…
60 or older	tax-free
Below age 60	taxed at the client’s marginal tax rate, less a 15% tax offset

By combining the above 15% tax offset and the Low-Income Tax Offset, clients under age 60 can effectively receive $55,437¹  a year tax-free from a disability super pension – and that’s assuming the pension is made up entirely of taxable component.

In addition, because such pensions are also treated as retirement phase pensions, the earnings derived by the assets supporting the pension will typically be tax-free.

The importance of tax components

As noted earlier, the tax components of a super disability pension are critical to the tax outcome. That means any tax-free component contained within the pension will only further increase the above mentioned effective tax-free threshold.

Unfortunately, as highlighted in last month’s Talking Technical article, the tax-free component uplift that applies to a lump sum superannuation disability benefit is not applied where a pension is created from the same super fund.

While pension payments can be quite tax effective, it’s worth remembering that clients can choose to take some of their income from the pension in the form of a partial lump sum commutation, rather than as a pension payment – so long as they take the required minimum annual payment amount in the form of pension payments.

So, although there is no tax-free uplift applied when the pension commences, if a client subsequently takes a partial lump sum commutation from their disability pension, the tax-free uplift may be applied to that lump sum.

Further, a lump sum commutation received by someone under age 60, will be taxed differently to regular pension payments. Depending on a client’s age and their marginal tax rate, choosing to take a partial lump sum commutation instead of regular pension payments may result in further tax savings.

Benefit of risk-only super policies

It’s important to remember that where a client’s cover is held under a risk-only super policy, it typically won’t have an accumulation component or be able to offer a pension solution. So, clients who would like to create a pension following a claim will need to roll some of their benefits over into another super fund that offers an appropriate pension solution.

Importantly, this rollover will trigger a tax-free uplift (refer to last month’s Talking Technical article). That means the pension, once established, will contain a potentially significant tax-free component.

Note: Where a client rolls over proceeds from one super fund to another, the trustee of the new fund will need to be satisfied that the client meets the conditions to receive a disability superannuation benefit. To do this, the new trustee(s) may request current medical evidence before applying the 15% tax offset.

So, from a tax perspective, using excess proceeds to commence a pension poses a relatively attractive option. However, there are a few advice considerations to be addressed.

• Transfer Balance Cap (TBC): As a disability superannuation pension will be treated as a retirement phase pension, it will be assessed against a client’s TBC. The TBC for 2023-24 is $1.9 million.
• Centrelink: Account-based pensions are assessed as an asset and treated as a financial investment subject to deeming under the income test. For clients who may be reliant on Centrelink benefits (e.g. Disability Support Pension), the amount that is used to commence a pension may affect their Centrelink entitlements – regardless of their age.

¹Some Medicare Levy may be payable

Another alternative to taking proceeds as a lump sum is to retain benefits in the superannuation accumulation phase.
While assets remain in the accumulation phase, the maximum tax rate of 15% will continue to apply to the fund earnings. So, while perhaps not as tax effective as using the proceeds to commence a pension, there are some benefits.

For example, retaining benefits in the accumulation phase can be useful for:

1. Deferring lump sum tax

This could be a useful consideration for a client approaching age 60 who would otherwise pay tax on a lump sum withdrawal. By retaining the benefits in the accumulation phase and deferring any lump sum withdrawal until after turning 60, clients can better manage the overall tax outcome.

2. Transfer Balance Cap limitations

This may be the only alternative to taking a lump sum withdrawal for clients who have already used or exceeded their TBC.

3. Centrelink benefits of sheltering

Assets held in the super accumulation phase are sheltered from Centrelink means testing until an individual reaches their Age Pension age.

This can benefit clients who may rely on Centrelink support after suffering a permanent incapacity, for example, someone claiming a Disability Support Pension, and who has not yet reached their Age Pension age.

Further, should a client require access to these super monies, any lump sum withdrawals from their accumulation fund will not be assessed as income for Centrelink purposes. That is, withdrawn amounts will only be assessable if they’re subsequently invested in a financial investment, such as a bank account or shares.

That means for clients who are likely to rely on Centrelink benefits, a tailored mix of a lump sum, pension and accumulation may be what is required to provide an optimal solution.

In addition to the potential Centrelink and tax benefits, retaining proceeds within the super system - either as a pension or in the accumulation phase - may also provide clients with different estate planning opportunities.

For instance, where TPD proceeds are taken as a lump sum following a client’s death, any remaining benefits will ultimately be subject to the terms of their Will and potentially exposed to challenge from a disgruntled beneficiary.

On the other hand, superannuation (both pension and accumulation) is not an estate asset. As such, super will not typically be dealt with by the provisions contained within a client’s Will but rather by the nomination option(s) chosen by the client before their death.

Being able to use a binding nomination to deal with superannuation benefits can provide added estate planning certainty to clients that their preferred beneficiary will receive proceeds following their death and that it is less likely these benefits can be challenged in court.

Further, lump sum death benefits paid to a tax dependant will not attract tax. So, for a client who would otherwise pay lump sum tax on any withdrawal made while they are alive, retaining assets in super and leaving proceeds to a tax dependant may also result in a better overall tax outcome.

We’ll have a deeper discussion on estate planning and death benefits in a future article.