Holding insurance within superannuation

Holding personal insurance through super may be worth considering for the right client, and advisers need to be aware of not only the benefits but also the tax consequences and complexity which could arise, Tim Howard writes.

When advisers think of superannuation the first things that tend to come to mind are contribution limits, preservation restrictions, and investment options.

Advisers may then consider retirement income projections in order to determine the viability of various superannuation strategies they are looking to recommend to their clients.

One of the better opportunities superannuation can offer your clients is something often not connected with retirement at all and that’s insurance cover.

Discussions around insurance cover within super rarely rate a mention when you come across articles highlighting the merits of super, however for many Australians the various benefits offered by holding certain types of insurance through super shouldn’t be overlooked.

Life insurance within superannuation

Superannuation is an effective way to not only provide individuals with a tax advantaged retirement benefit, but it is also a great way to hold insurance for the benefit of the funds’ members or their dependants.

By far the most common type of insurance held via super is life insurance.

It’s important to firstly understand the practical implications for a person in the event they hold life insurance through super and were to pass away.

While life insurance proceeds from a policy held personally would generally revert to the individual’s estate upon death, tax-free in most instances, there are a number of extra steps which take place when insurance is held within an individual’s super fund.

Firstly, the insurance proceeds will be paid by the insurer to the trustee of the super fund in the event of claim. These proceeds will, in effect, be combined with the deceased members’ accumulated account balance to form the deceased member’s death benefit.

Under the Superannuation Industry (Supervision) Act (SISA), following the death of the member, the super fund trustee is required to pay the deceased member benefit (member account balance plus insurance proceeds) to an eligible beneficiary or the legal personal representative of the deceased member.

Certain eligible beneficiaries at this point may be eligible to take an income stream benefit in the form of a death benefit pension, with the tax treatment of this pension being determined by the age of the deceased at the date of their death and the age of the beneficiary at the date of payment.

Alternatively, when a lump sum death benefit is taken the tax treatment of the lump sum depends on the payment having been made to either a dependant or non-dependant of the deceased member as defined under the Income Tax Assessment Act 1997 (ITAA 1997).

While a tax dependant would receive the benefit tax-free, they may be tax consequences where the benefit is paid to a non-tax dependant.

The primary advantages and disadvantages of holding life insurance through super are outlined below.

TPD within super

While holding life insurance through superannuation can provide members with the opportunity to tax effectively fund insurance cover for their dependants in the event they were to pass away, the merits of holding total and permanent disablement (TPD) cover through super should also be considered.

Much like the various considerations around holding life insurance through super, an individual needs to be aware of the practical implications of holding TPD insurance cover through super.

The ultimate benefit amount the member would receive along with the tax treatment of the proceeds will be influenced by the following factors.

Firstly, in the event of claim the member will need to satisfy the TPD definition as per the insurer’s policy in order for the sum insured to then be paid to the trustee of their super fund.

Once met and paid, the insurance proceeds will form part of the members account balance. The member will then need to meet the definition of “permanent incapacity”, which is found in the Superannuation Industry (Supervision) Regulations 1994 (SISR).

Importantly, if the member didn’t meet the permanent incapacity definition, which in most instances would be highly unlikely as both insurance policy and superannuation condition of release definitions need to align for new policies held in super from 1 July 2014, the member may still meet one of the other superannuation conditions or release such as retirement after reaching their preservation age.

Finally, if the member elects to take a lump sum payment from their super fund, this payment will be treated as a lump sum superannuation benefit and taxed accordingly based on the member’s age and the components of the benefit payment.

Where the definition of a disability superannuation benefit in subsection 995-1(1) of ITAA 1997 can be met, the benefit received by the member can include an increase in the tax-free component as a result of the formula found in section 307.145 of ITAA 1997.

In the event the member is looking to take a disability pension, rather than a lump sum, in order for the increase in the tax-free component to occur the member can look to rolling their benefit to a second superannuation fund before taking a pension.

While taking a disability pension for their original super fund, in the first instance, won’t result in an increase in the tax-free component, a rollover is treated as a commutation when applying the formula in section 307.145 of ITAA 1997 and therefore would allow for a more tax effective pension for members under the age of 60.

While historically “own” and “any” occupation TPD insurance policies could be held through superannuation, from 1 July 2014 new policies need to alight with the superannuation conditions of release and as a result you are no longer able to hold new ‘own’ occupation TPD policies through super.

Example

TPD lump sum

Andrea was born on 4 May 1970. Unfortunately, Andrea was recently in an accident which resulted in her becoming totally and permanently disabled on 4 April, 2016.

Andrea currently has $103,000 in superannuation of which $100,000 is the taxable component and $3,000 is tax-free. She also holds $300,000 worth of TPD cover through her fund.

Andrea’s eligible service date is 1 January, 1995, and her retirement day is taken to be when she reaches age 65 on 4 May, 2035.

She has decided she would like to take a superannuation lump sum benefit to clear her mortgage.

Prior to taking her member benefit as a lump sum and following her accident, her fund components are as follows:

Taxable component = $400,000 ($100,000 balance + $300,000 TPD insurance proceeds).

Tax-free component = $3,000

Total = $403,000 (1 per cent tax-free, 99 per cent taxable)

After meeting a permanent incapacity condition of release and electing to take all of her benefit as a superannuation lump sum her components are as follows:

Taxable component = $209,373

Tax-free component = $193,627

Total = $403,000 (48 per cent tax-free, 52 per cent taxable)

NB: Although there is a significant uplift in Andreas tax-free component, as she is 46 years old she will still need to pay tax on the taxable component of her superannuation lump sum at a maximum tax rate of 22 per cent (including Medicare).

Salary Continuance within superannuation

Many advisers will be familiar with income protection insurance cover being held personally by individuals due to the deductibility of premiums and the additional ancillary benefits personally held income protection policies might offer.

Income protection held through super is often referred to as salary continuance insurance as well as sometimes being referred to total and temporary disablement cover (TTD).

Where a member holds salary continuance insurance through their super fund and then becomes temporarily disabled, the amount of their benefit and ultimately the benefits tax treatment will come down to the following considerations.

Firstly, the member will again need to meet the insurer’s policy definition in order to be eligible to claim on the insured benefit. Once met, the insurance proceeds will be paid to by the insurer to the trustee of the member’s superannuation fund.

The member will then need to satisfy a condition of release, which in the first instance will usually be the definition of temporary incapacity, therefore allowing for an income stream benefit (in most cases in the form of the insurance proceeds) to be paid to the member. Like mentioned above, another condition of release could be met under certain circumstances such as retirement after reaching your preservation age.

Unlike TPD pension payments, salary continuance proceeds paid to a member are not eligible for a 15 per cent tax offset, regardless of the members’ age. Salary continuance benefit payments, like income protection insurance, are intended to be direct compensation for lost income as a result of the individual’s illness or injury. As a result the payments will be considered as ordinary income and required to be included in the individual’s income tax return.

Like life and TPD insurance premiums, the trustee of a complying superannuation fund is able to claim a tax deduction under section 295-465 of ITAA 1997 for salary continuance insurance premiums.

Holding certain forms of personal insurance cover within super can provide a number of benefits for your clients, whether it’s to improve their cash flow, provide an indirect deduction for the premiums which wouldn’t otherwise have been available if cover was held personally or to provide either the member or their beneficiaries with a tax or structurally effective benefit in the event of claim.

For the right clients, holding their personal insurance cover through super may well be worth revisiting.

Along with these benefits, advisers need to be aware of the potential accessibility issues, potential tax consequences and extra layer of complexity which can arise when you are not just dealing with the insurer for your client’s insurance cover, but also the interaction with various pieces of legislation.