The untaxed element of super lump sums and death benefits: public sector schemes, the untaxed plan cap, and tax treatment for retirees and dependants

For Australian public sector employees — Commonwealth, state, and certain statutory authority members — and their families, super benefits often include an untaxed element that produces materially different tax treatment from the standard "taxed source" super benefits that most private sector members receive. The untaxed element of the taxable component is defined in section 307-275 of the Income Tax Assessment Act 1997 (accessed 16 May 2026): broadly, the portion of a super lump sum or death benefit that comes from a fund that did not pay the standard 15% contributions tax during the member's accumulation phase. Typical sources are older public sector defined benefit schemes (PSS, CSS, MilitarySuper, DFRDB, various state schemes) operating as "unfunded" or constitutionally protected arrangements with benefits paid from consolidated revenue rather than a fund accumulating contributions in the standard way. The untaxed plan cap under section 307-345 of the ITAA 1997 (accessed 16 May 2026) caps the favourable concessional tax treatment available for untaxed amounts at $1,865,000 for FY25-26 (the cap indexes to AWOTE alongside the CGT cap; ATO — key super rates and thresholds, accessed 16 May 2026), with amounts above the cap taxed at top marginal rates. For public sector retirees nearing retirement and their family members planning for death benefits, understanding the untaxed element framework is essential to retirement income decisions, rollover timing, and dependant tax outcomes.

The distinction between taxed and untaxed source is fundamental and often misunderstood. A "taxed element" of the taxable component comes from funds that paid the 15% contributions tax during accumulation — the standard framework for almost all APRA-regulated industry funds, retail funds, and self-managed super funds. An "untaxed element" comes from funds where this tax wasn't paid — most commonly older public sector schemes where the employer entity (Commonwealth or state government) bears tax obligations differently, or where the scheme operates without a standard accumulation fund and benefits are paid from general revenue (ATO — tax on withdrawals of super, accessed 16 May 2026). For the member, the eventual super benefit typically separates into a taxable component (with possible taxed and untaxed elements) and a tax-free component (representing personal undeducted contributions and similar). When the benefit is paid as a lump sum or death benefit, each element is taxed under different rules — and the untaxed element attracts the specific framework discussed here.

The principal sources of untaxed elements in the Australian super landscape include the Commonwealth Public Sector Superannuation Scheme (PSS), the closed Commonwealth Superannuation Scheme (CSS), MilitarySuper for Australian Defence Force members, the Defence Force Retirement and Death Benefits (DFRDB) scheme, and various other Commonwealth schemes covering specific cohorts. State public sector schemes in each state — for example State Super (NSW), QSuper public sector divisions (Qld), GESB West State (WA), Triple S (SA) and equivalents — have similar untaxed structures depending on scheme design. Constitutionally protected funds (CPFs) are a specific category of state public sector schemes with constitutional protection from federal tax that produces untaxed-element treatment. Some older statutory authority schemes — Reserve Bank, certain government business enterprises that were previously closer to public sector arrangements — may also have untaxed elements. For most members of these schemes, some or all of the eventual super benefit is "untaxed source", with the proportion depending on the period of membership, contribution history, and rollover patterns.

The untaxed plan cap is the central quantitative constraint. The cap of $1,865,000 for FY25-26 defines the maximum amount of untaxed element that a member can receive from a single fund with concessional tax treatment in their lifetime — above the cap, the excess attracts top marginal rate (47% including Medicare levy). The cap is per fund per member. For most public sector members, the cap is well above their eventual benefit and not a binding constraint. For long-tenure senior members of well-funded schemes — typically Commonwealth executives, military officers approaching the top, and certain state senior public servants — the cap can become binding, with substantial excess amounts attracting punitive rates if taken as a lump sum.

The tax treatment within the cap depends on the recipient's age and the type of payment (set out in section 301-100 of the ITAA 1997, accessed 16 May 2026). For lump sums to recipients aged 60 and over, the untaxed element within the cap is taxed at 15% plus Medicare levy = 17%. For lump sums to recipients under 60 but at or above preservation age, an amount up to the low rate cap (the same threshold used for the taxed-source low-rate cap) of the untaxed element is taxed at the same 15%-plus-Medicare = 17% rate, with the remainder up to the untaxed plan cap taxed at 30% plus Medicare levy = 32%. Above the untaxed plan cap, all amounts are taxed at 45% plus Medicare levy = 47%. For pensions paid from untaxed sources, the income is included in the recipient's assessable income at marginal rates, with a potential 10% tax offset for over-60 recipients applying to the taxable untaxed portion of the pension income. The interplay between lump sum and pension treatment is one of the central retirement-decision considerations for public sector members.

The death benefit treatment for untaxed elements is similarly distinctive. For death benefits paid to tax dependants (spouse, dependent child under 18, financial dependant, interdependant — under ITAA 1997 s.302-195), the lump sum is generally tax-free, though the component analysis still affects estate planning and any subsequent distribution. For death benefits paid to non-tax-dependants (typically adult independent children), the taxable component attracts higher tax rates, with the untaxed portion subject to 30% plus Medicare levy = 32%, compared with 15% plus Medicare levy = 17% for the taxed-source taxable component. The differential rates for non-dependant recipients can make the untaxed element a substantially more expensive estate planning issue than equivalent taxed-source benefits — for a $400,000 untaxed taxable component to an adult child, the tax cost is approximately $128,000 (32%), versus approximately $68,000 (17%) for a taxed-source equivalent.

The rollover option at retirement is the principal planning lever for many public sector members. The member elects to roll over the untaxed amount from the public sector scheme to a taxed fund (industry, retail, or SMSF). The receiving fund pays the 15% contributions tax to the ATO on the untaxed element of the rollover. The net amount (after the 15% tax) is added to the taxed-source balance in the receiving fund. The rollover counts against the untaxed plan cap, with potential excess tax if the cap is breached on rollover. After rollover and tax payment, the amount is "taxed source" for future treatment — meaning it can be commenced as a tax-exempt retirement-phase pension (for over-60 retirees), rolled over again without further tax, drawn as a lump sum subject to standard taxed-source treatment, and bequeathed as a death benefit under the standard framework. The rollover is strategically valuable for members who plan to draw the benefit as an account-based pension or use a TBC-managed structure; it converts untaxed status to standard framework at a 15% conversion cost. For members who plan to take the benefit as a defined benefit pension within the scheme, no rollover is needed — the in-scheme pension is taxed at marginal rates with offsets and operates within the public sector framework. The related article on articles/2026-05-04-defined-benefit-pension-16x-special-value-tba covers the special-value TBC treatment that applies to in-scheme lifetime pensions.

The interaction with the Transfer Balance Cap (TBC) adds further complexity. Public sector defined benefit pensions typically have a "special value" calculation for TBC purposes (×16 the annual pension payment for certain lifetime pensions under ITAA 1997 s.294-135). The TBC counts the special value against the member's $2.0 million general TBC. Untaxed-source amounts converted to taxed source via rollover and then commenced as an account-based pension count against the TBC at the face value of the rollover. There's also a $125,000 defined benefit income cap that applies for income tax purposes for over-60 recipients of defined benefit pensions — above this annual amount, only 50% of the pension income is included in assessable income (rather than the standard tax-free treatment). For high-balance members, the interaction with the untaxed plan cap, the TBC, the defined benefit income cap, and the rollover decision requires careful modelling — there is no single dominant strategy.

The practical advice work for public sector retirees and their family members has a specific shape. Identify the component composition by reviewing scheme statements and confirming with the fund administrator what is taxed, untaxed, and tax-free. Confirm untaxed plan cap availability including any prior usage in earlier rollovers or partial commutations. Model retirement options — full lump sum, full defined benefit pension, partial commutation with residual pension, full rollover to taxed fund with subsequent account-based pension, hybrid combinations — using the member's specific scheme rules and tax position. Plan death benefit treatment considering both spouse-as-dependant scenarios and adult-child-as-non-dependant scenarios, with the untaxed-source rate differential factored in. Consider rollover timing — rolling over earlier locks in current cap and current contributions tax rate; rolling over later preserves optionality but exposes to future cap and rate changes. Coordinate with broader retirement strategy including TBC management, NCC space utilisation if the member has additional super, and estate planning for the residual estate. Document elections carefully — many public sector scheme decisions are irrevocable, and the choice between in-scheme pension and rollover lump sum is typically a one-time decision at retirement.

What do worked planning examples show?

These two cases show how the untaxed element framework plays out for typical public sector scenarios. Illustrative only — not personal advice — using FY25-26 figures.

Case 1 — Robert, 65, retired Commonwealth public servant. PSS balance $1.4m (mostly untaxed). Spouse Helen, 63. On these facts, Robert's balance is below the $1,865,000 untaxed plan cap. Options at retirement: (a) full lump sum — taxed at 17% on the untaxed element ($238,000 tax on a $1.4m balance, ignoring any tax-free component), net around $1.16m; (b) defined benefit pension — taxed at marginal rates with a 10% tax offset for over-60s on the taxable untaxed portion, providing approximately $80,000–$100,000 a year indexed for life (specific amount depending on scheme conversion factor); (c) partial commutation — take $400,000 lump sum (taxed at 17% = $68,000), retain residual pension entitlement. The choice depends on Robert's other resources, longevity expectations, and Helen's retirement plans. The trap to avoid is taking the full lump sum without modelling the pension option — for many members with substantial life expectancy, the in-scheme pension produces better lifetime economics, even with the 10% offset rather than full tax-exempt treatment.

Case 2 — Susan, 67, retired senior NSW state public sector. Defined benefit balance $2.4m (substantially untaxed). Receiving in-scheme pension of approximately $130,000 a year. On these facts, Susan's balance exceeds the $1,865,000 untaxed plan cap by approximately $535,000. If she had taken the full lump sum at retirement, the excess would have been taxed at 47% (approximately $251,000 tax on the excess), with the within-cap portion at 17% (approximately $317,000 tax). The in-scheme pension election avoided the cap-related lump sum tax — pension income is taxed annually at marginal rates with the 10% offset, and the defined benefit income cap of $125,000 limits the assessable portion (above $125,000, only 50% of the excess pension income is assessable). The trap to avoid is failing to model the cap impact before electing lump sum — for high-balance members, the untaxed plan cap can transform a routine retirement decision into a major tax event.

For Australian public sector retirees and their families, the untaxed element framework under sections 307-275, 307-345, and 301-100 of the ITAA 1997 produces tax outcomes that differ materially from standard taxed-source super treatment. Within the untaxed plan cap ($1,865,000 for FY25-26), the rates are concessional but not zero — 17% for over-60 lump sums, 32% non-dependant death benefit rate, marginal rates with a 10% offset for in-scheme pensions. Above the cap, top marginal rates apply. The rollover option converts untaxed to taxed status at a 15% cost, supporting subsequent TBC structuring and pension-phase tax exemption. For members of PSS, CSS, MilitarySuper, and similar schemes, the untaxed element analysis is part of the routine retirement planning conversation. The advice work is to model the options, address the cap and TBC interactions, and document the chosen pathway clearly.

Sources

• classic.austlii.edu.au — S307.275
• classic.austlii.edu.au — S307.345
• classic.austlii.edu.au — S301.100
• Australian Taxation Office (ATO) — Key superannuation rates and thresholds
• Australian Taxation Office (ATO) — Tax on withdrawals of super