Don’t Generate an Untaxed Element!
Our last Snippet focused on the future service benefit tax deduction. The example showed how a tax saving of about $87,000 could be made if a life insurance policy funded any part of the $1m payment to the member, or tax dependent, within the parameters described. The flip side is the consequence if the benefit is paid to a non-tax dependent.
An untaxed element may be generated, resulting in an additional 15% tax being applied to taxable death benefits, where non-tax dependants receive a lump sum payment if a deduction for life insurance premiums or future service has been taken. Importantly, the untaxed element is calculated on the whole benefit, not only that increment attributable to life insurance proceeds.
A payment to a non-dependant for tax purposes incurs 15% tax on the taxed, taxable component but an additional 15% on any untaxed, taxable component.
If the lump sum payment is made to a tax dependent such as a spouse, minor child, financial dependant or interdependent, or if the benefit is paid as a pension, no adverse tax position arises. If this is not the case, typically the situation where there are only adult independent children as beneficiaries, then inclusion of life insurance in the Fund for which tax-deductible premiums have been paid creates a problem.
The untaxed element is calculated using the formula provided in Section 307/290 of the Income Tax Assessment Act. In the future service benefit example mentioned previously, the tax saving of around $87,000 would be reversed as it would approximately reflect the additional tax payable by non-tax beneficiaries.
As the tax saving is achieved by carrying forward the income tax deduction it may take some time to realise, or even be lost in certain circumstances, but the additional tax payable is due at the time of the payment. Consequently, holding life insurance in the fund where the benefit recipients will not be tax dependants should be avoided as this can trigger the additional tax irrespective of whether or not the future service deduction is taken.
Access to our untaxed element calculator is available to our alliance partners.