Considering the pros and cons of insurance in super

Having insurance cover in super is often seen as an attractive way to structure some or all of a clients benefits. The tax deductibility of premiums paid by the fund trustee that are not deductible outside of super is an obvious attraction. The ability for clients to pay for insurance cover from accumulated super where cash flow is limited presents another attractive option and allows you to protect clients who may not have otherwise been able to afford cover. 

Additionally, there are advantages for your self employed clients making personal contributions to super as a way of funding premiums while claiming the value of contributions as a deductible expense. Any of these scenarios make legitimate cases for using super to structure ownership of your clients’ policies.  It can often assist in overcoming what is often significant inertia in convincing clients to protect themselves by taking out the cover they really need.

So while super ownership has many advantages, how much consideration is given to the implications if the client has to make a claim? This is the time when you most want the cover you recommended to deliver.

Tom Gordon

National Technical Sales Manager - Product

Copyright © 2013 AIA Australia Limited (ABN 79 004 837 861 AFSL 230043). All rights reserved. This information is intended for financial advisers only and is not for wider distribution. This information is current at the date of distribution and is subject to change. This is general information in summary only, without taking into account the objectives, financial situation, needs or personal circumstances of any individual, and may not be exhaustive. It is not intended as financial, legal, medical or other advice.

Summary

 Insurance plays a critical role in ensuring that the right amount is paid to the right people at the right time. 

Structuring insurance in super needs consideration of whether any tax payable on benefits will impact paying the right amount and how superannuation conditions of release could impact on payment at the right time.

Think of the implications if the client has to make a claim.  This is the time when you most want the cover you recommended to deliver.

Under superannuation law, a dependent includes a spouse (including a de facto partner or former spouse), a child (including an adopted, step or ex-nuptial child) under 18, any person who is financially dependant on the deceased or any person with whom the deceased has an interdependent relationship

Let’s look at how the different tax treatments will work in practice.

Case study

John is 44 and purchased life, TPD and income protection cover through his Self Managed Super Fund (SMSF). He nominates his wife and two children (aged six and nine) to receive his life cover. The SMSF claims the premiums as a tax deduction each year to reduce the tax payable in his SMSF.

Scenario 1 - TPD

John is involved in a car accident at age 50 and suffers permanent injuries that prevent him from ever working again. He satisfies the policy definition for TPD so the insurer pays his TPD benefit to his SMSF. He also meets the ‘Permanent incapacity’ test in super so the fund trustee can pay him a benefit. The taxable component of his TPD benefit is $500,000 and since he is under 55 years of age, the trustee deducts tax of $107,500 (21.5%). John receives a net benefit of $392,500.

If John had become permanently incapacitated at 59 instead of 50 then he would have received a higher benefit after tax. Based on the same taxable component of $500,000, the trustee would deduct tax of $52,800 leaving him with a net benefit of $447,200. The tax is calculated as follows:

•           The first $180,000 is tax free.

•           The remaining $320,000 is taxed at 16.5%.

If John had become permanently incapacitated aged 60 or older then he would have received the entire benefit tax-free.

Scenario 2 – Life

John passes away at 50. He has life cover with a sum insured of $1,000,000 which is to be distributed to his wife (50%) and his two children (25% each). His wife and two children all meet the definition of ‘dependant’ so receive their share of the benefit tax-free.

If John had passed away at 59 instead of 50 the circumstances could be different. While his wife would still be entitled to receive her portion of the benefit ($500,000) tax free, his children are now aged over 18. His youngest child is studying at university and was financially dependent on John when he died. This child would be entitled to receive their portion of the benefit ($250,000) tax-free. The older child is working and no longer financially dependent so must pay tax on their portion of the benefit ($250,000). Because John’s SMSF had claimed a tax deduction in the past for premiums it paid, their portion of the benefit is taxed - at 16.5% on the element taxed and 31.5% on the element untaxed, which are calculated based on service days and days to retirement using the modified proportioning rule.

So what could the adviser have done to maximise the benefit paid to John or his beneficiaries?

1. Consider grossing up the sum insured to offset the tax that may be payable
2. Review the sum insured each year to ensure that it adjusts to the changing circumstances 

For example, after John turns 55 the tax he’d pay on a TPD benefit will reduce so the gross amount of cover he needs may be reduced. When John’s eldest child becomes a non-dependant then John may consider changing the sum insured or the proportion of his benefit to be paid to each beneficiary.

Satisfying the trustee

Superannuation law only allows benefits to be paid to the member where a condition of release is met. This can cause problems where the insurer’s policy terms are more generous than the super ‘condition of release’ – think of ‘own occupation’ TPD cover. This can have the effect of ‘trapping’ benefits in super. Trustees would typically only pay a benefit for an ‘insurable event’ under the following circumstances:

Issues can typically arise for disability benefits. While a TPD benefit may be paid by the insurer under an ‘own occupation’ definition or for the loss of use of sight or limbs, these disablements may not meet the stricter ‘permanent incapacity’ test when applied by the fund trustee. Similarly, the trustee may pay an income stream benefit provided that it is for no more than 100% of the client’s income prior to disablement. Any benefit paid by the insurer in excess of 100% could be trapped in super.

While members aged 55 or older have greater flexibility as they may be able to access ‘trapped’ benefits by meeting the ‘permanent retirement’ condition or accessing an income stream by setting up a transition to retirement (TTR) pension. If they are under 55 years of age, they could apply under ‘Severe Financial Hardship’ however the maximum benefit is limited to $10,000 per year and the application process can be onerous.

Tax treatment of benefits

It is universally accepted that there ‘ain’t no such thing as a free lunch’. If the Government provides tax incentives upfront it often means tax consequences at the back end.   

The tax treatment of insurance benefits will vary depending on the type of cover and the age it is paid to the beneficiary. Income protection benefits are taxed as income, regardless of whether the policy is owned by the individual or the fund trustee, and terminal illness benefits paid to the life insured are tax-free. However, the same is not true for life and TPD benefits. 

The table below provides an overview of the key differences:

[1] Includes Medicare levy of 1.5%.

[2] Includes Medicare levy of 1.5%.

[3] Lifetime cap applicable for 2012/13. Indexed annually to AWOTE.