Future service tax deductions - some traps for the unwary

When an SMSF member with insurance dies before 65 there is potentially a special tax deduction available known as a “future service” deduction. But it’s surprising how often an SMSF can’t claim it – what are the traps and how can you avoid them?

No-one takes out insurance hoping to claim on it. And these days most people hope to make it to 65. But in the unfortunate event that your client dies too young, it makes sense to take as many tax breaks as possible – including large tax deductions in their SMSF. One of these is the “future service” deduction.

 What is it?

SMSFs with life or permanent disability insurance for their members usually claim a tax deduction each year for the insurance premiums paid. And that makes perfect sense. But there’s a special rule that gives every superannuation fund (including SMSFs) a once only chance to change their mind about how they treat these premiums when a member dies and a death benefit is actually paid out (either as a lump sum or by starting a pension). (And note the same special rule applies when a member becomes permanently incapacitated and a permanent incapacity benefit is actually paid out). In that year, the trustee can make a choice that instead of claiming a tax deduction for the insurance premium paid, they will claim a tax deduction for part of the benefit.

The deduction is called a “future service” deduction because it’s calculated in a way that tries to divide the death benefit into two parts, ie between:

• the number of years the member has been building up their super to date (the first part), and
• the numbers of years until they turn 65 (the second part).

The tax deduction is the second part – the proportion that relates to their “future service” (that they didn’t live to complete).

A simple example – if Chris started building up his super at age 25 and died at 45 (20 years to go until he gets to 65), then his “future service” component will be roughly 20/40 (50%) of his death benefit.

Why claim it?

In the example above, the SMSF might well have been claiming a tax deduction for insurance premiums for Chris and his wife Carole (also a member of the SMSF) for years.

So why would the trustee change the approach now and claim a future service deduction instead?

Because it means the deduction available “now” is very large. In this example it’s 50% of Chris’ death benefit. And remember that’s the whole benefit (which will include any insurance that’s been added to his super balance). If Chris had $400,000 built up in super already and life insurance of $1m, his total death benefit would be $1.4m. The tax deduction would be $700,000. It doesn’t matter whether this amount is paid out as a lump sum or as a pension to Carole or a mixture of the two, the total death benefit is still $1.4m and the future service deduction would be $700,000.

Doing so would mean the fund could never claim a tax deduction for insurance premiums again. If Carole also has insurance in the fund, for example, her premiums wouldn’t be tax deductible in the future. The same would apply if anyone else ever joined the fund in the future – this is where the choice is a “once off” choice. (This is why most large funds don’t do it – for them, it makes more sense to claim tax deductions for the premiums every year.)

But SMSFs are potentially in a unique position here. They often have two members who both have insurance. If just one dies, it’s entirely possible that the survivor either won’t have insurance for much longer (given their age) or won’t need the insurance (since they will have claimed on their deceased spouse’s cover). Either way, they are often better off to make the switch.

But there are some traps that mean many SMSFs can’t claim this deduction.

Work condition

For a start, the benefit has to be paid “in consequence of the termination of a [deceased] member’s employment”. So it’s only possible if the deceased was still working at the time they died. (Note that the same choice is actually also possible if the member has become permanently incapacitated and a disability benefit is being paid. But the same issue applies – they have to be working and the benefit payment needs to be triggered by their termination of employment due to their injury or illness.)

Premium timing

Perhaps more problematic for SMSFs is the timing of premium payments. A recent case we put to the ATO highlighted some major challenges for most SMSFs in taking advantage of this deduction.

Our case was very similar to Chris and Carole. Our “Chris” died unexpectedly in December 2020. He had been working up until his death and so met the work condition. A death benefit was paid for him in June 2021.

In our example, both Chris and Carole had life insurance via their SMSF and the premiums were paid annually – in March and January respectively.

Because Chris died before his annual premium was due (March 2021), no insurance premiums were paid for him in 2020/21. But the normal premium was paid for Carole in January 2021.

The ATO denied the future service deduction. Their rationale was that the trustee can’t “choose” to claim a tax deduction for the future service part of the death benefit paid in 2020/21 rather than the premium in 2020/21 because there was no insurance premium paid for Chris in that year.

It didn’t matter that the fund was still paying insurance premiums (for Carole) or that the fund had paid life insurance premiums for Chris over many years. They key was that nothing was paid for Chris in the relevant year.

This suggests that it’s important to make sure premiums are paid regularly throughout the year – to maximise the chance that a premium is actually paid for the deceased in the year their death benefit is paid. Or if premiums are paid annually, make sure the anniversary date is July and pay the death benefit in that same financial year. Otherwise, most SMSFs will miss out on this benefit.

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