Advisers must look beyond the controversy from the recent Budget and determine what opportunities and risks it offers for their clients, David Glen writes.
As the dust settles on the 2014 Federal Budget, advisers providing life insurance should consider the impact of the announced measures on current and future client strategies.
The initial reaction would be that the announcements would have no impact, as the 2014 Federal Budget contained no life insurance specific matters. However, if the announcements are enacted there will be an impact for clients and their risk strategies which will require review. While we will not know for some weeks which Budget changes will pass through Parliament intact and which will not, advisers need to give consideration to the impacts of the proposed changes.
Effective marginal rate increase
The fundamental impact lies in the effective increase in marginal tax rates caused by these measures. A tax or a levy increases the effective tax rate, irrespective of the words used to sell the measures.
The maximum marginal tax rate under these measures is effectively 49 per cent with effect from 1 July 2014. This comprises the nominal maximum marginal tax rate of 45 per cent, which applies to all taxable income in excess of $180,000 per annum. The Medicare levy, which is an additional impost, is set to increase to 2 per cent with effect from 1 July 2014.
Taking the maximum marginal tax rate to the new level of 49 per cent for higher income earners is the proposed additional impost of the Budget Deficit Levy effective from 1 July 2014. The Budget Deficit Levy is set at the rate of 2 per cent of the excess of taxable income over $180,000. The Budget Deficit Levy is “temporary”, and will apply for three years. Time will tell whether or not the temporary levy becomes a permanent feature of the Australian taxation system.
Cost of life insurance outside Super increases
Prior to the 2014 Budget announcement, life insurance outside superannuation for those on the maximum marginal tax rate carried an after tax cost of $1.86 for every $1 of premium paid. Tax paid at 46.5 per cent on the $1.86 was $0.86, leaving $1 after tax to fund the premium.
An effective maximum marginal tax rate of 49 per cent increases the cost of insurance held outside superannuation for these taxpayers to an after tax cost of $1.96 for every dollar of premium paid. Tax paid at 49 per cent on the $1.96 is $0.96 leaving $1 after tax to fund the premium.
The Fringe Benefit Tax (FBT) rate will also be increased to 49 per cent from 1 April 2015 until 31 March 2017 to ensure that the FBT rate aligns with the effective maximum marginal tax rate. This measure will prevent high income earners being remunerated in the form of fringe benefits in order to avoid the Budget Deficit Levy.
The change in the FBT rate will increase the cost of life insurance arrangements of certain enterprises where premiums for policies on the lives of employees are paid on behalf of employees by the employer. For example, the premiums on life insurance policies funding a buy/sell arrangement of the proprietors may be subject to FBT. In this situation, the increase in the FBT rate will also increase the cost of these arrangements.
Importantly, the new FBT rate applies irrespective of the levels of taxable income of the recipients of those benefits. It may therefore be advantageous to restructure these financial arrangements where the lives insured have taxable incomes below $180,000 per annum. These individuals could fund the premium cost from additional salary payments which would be taxed at the marginal rate of the recipient. For example, if the taxable income of the life insured is $90,000, the additional salary to fund the premium cost will attract tax at the marginal tax rate of 39 per cent. This option may be cheaper than the employer entity paying the premium, and being subject to FBT at the rate of 49 per cent.
Policies which are owned by employers and are used for the benefit of the employer such as key person cover would not be impacted by the Budget Measures, as the payment of these premiums is not generally subject to FBT.
Insurance in Super more attractive
Increases in tax rates improve the benefit of tax deductions. Insurance in superannuation allows for the payment of life insurance from pre-tax income via employer contributions into superannuation. In the case of the self-employed, the cost of contributions funding the life insurance is tax deductible to the member.
Therefore, the effective increase in tax rates may increase the demand from clients to place their life insurance requirements within a superannuation structure. The cost of life insurance in superannuation remains at $1 for every $1 premium paid, while insurance outside superannuation has become more expensive at $1.96 for every $1 premium paid. Insurance in superannuation will also become more attractive as a result of the increase in contribution caps effective from 1 July 2014.
The bias towards insurance in superannuation will however be offset by the new measures effective from 1 July 2014, which will only allow superannuation funds to hold life insurance contracts where the benefits under the contract are those are permitted by the “Conditions of Release” under the Superannuation Industry (Supervision) Regulations 1994 (Cth). Examples of life insurance contracts no longer permitted under these regulations include own occupation cover in super, trauma insurance within a Self-Managed Super Fund, and income protection insurance contracts in superannuation with lump sum ancillary benefits. These measures do not apply to life insurance contracts in super which are in force prior to 1 July 2014. Therefore, advisers should be reviewing their clients’ requirements to ensure that where appropriate these life insurance policies are issued prior to 1 July 2014.
Punitive tax can be avoided
A positive feature of the Budget announcements is the measure that with effect from 1 July 2014, the penalty on excess non-concessional contributions may be avoided. The measure will allow for the withdrawal of the excess and associated earnings from the superannuation system instead of paying the punitive tax. The withdrawn earnings will be taxed at the member’s marginal tax rate.
This measure is welcome for life insurance in superannuation. Many superannuation fund members have inadvertently breached the non-concessional contribution caps by funding their life insurance needs through additional contributions to superannuation. These individuals may have contributed up to the amount of the caps by making contributions funding their retirement savings. Under the existing superannuation measures, these individuals faced the unpleasant prospect of the punitive excess non-concessional contribution tax on contributions funding their insurance needs. This penalty could create an effective tax rate of 93 per cent in certain circumstances.
No comfort on regulatory risk
Using the superannuation system for estate planning and other risk mitigation techniques always carries a regulatory risk factor. We cannot be certain that the rules will remain unchanged. Risk mitigation and estate planning involve the implementation of long term strategies where everyone desires certainty of outcome. Unfortunately, Governments of all political persuasions are prone to tinkering with the superannuation system to eliminate perceived problems and inappropriate outcomes.
The 2014 Budget announcements contained no major structural changes in the superannuation system. However, there is no assurance that the existing system will remain intact in the medium to long-term. There has been considerable debate in recent months concerning the effectiveness of the superannuation system funding retirement savings. This creates an atmosphere of uncertainty concerning outcomes.
Way Forward
Monitoring strategies and assessing the impact of any regulatory change is an important part of the risk management services provided by life insurance advisers. The 2014 Budget announcements provide both a challenge and an opportunity to add value to clients through pro-active education on the issues involved and strategies to deal with change including appropriate costings.
David Glen is national technical services manager at TAL.
