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Insurance is a critical component of a well-rounded financial plan. However, the cost of insurance can have an impact on cash flow, leaving many people with insufficient cover.
One way of reducing the cost is to hold insurance within superannuation, so that premiums are funded by accumulated superannuation benefits. However, this can reduce the end retirement benefit.
The abolition of reasonable benefit limits in 2007 greatly reduced the tax implications of structuring death, and total and permanent disability (TPD) insurance in superannuation. In most cases, there will be no tax on superannuation death benefits (where paid to tax dependants) and extended tax concessions apply for disability benefits.
The key benefit of holding insurance in superannuation is that the superannuation fund can claim a tax deduction against assessable fund income for the cost of the premium relating to death, TPD and, sometimes, salary continuance cover. If the cover is outside superannuation and the taxpayer is an individual, they are not eligible to claim death and TPD premiums as a tax deduction.
Depending on the superannuation fund, if the member has ‘assessable income’ in the fund, such as investment earnings or taxable contributions, the fund may pass on the benefit of this deduction to the member by offsetting that assessable income.
Consideration needs to be given to the method of funding this cover within superannuation. While the fund itself is funding the cost of the cover, it passes the cost on to the member. The member has two options to fund the cover:
- if they have accumulated investment benefits, they can elect to simply have the cost deducted from those benefits; or
- they can make additional contributions to fund the cost of the cover.
Option two helps members maximise the cash flow and superannuation benefits of holding the cover within superannuation.
To get an insight into how these options would work, let’s examine the process through a case study.
Case study
Amy is an employee with a salary package of $109,000 (including superannuation guarantee contribution). She has no insurance cover, but her financial adviser has suggested taking death and TPD cover equivalent to a premium of $4,000 per annum. She has agreed, and her financial adviser investigates five scenarios for funding this cover as follows.
- The insurance policy is owned by Amy who funds the premium out of her after-tax salary.
- The insurance policy is owned within superannuation with Amy funding the premium by making an additional equivalent personal contribution. For the purposes of this scenario, we assume the contribution is made to the same fund to which her employer contributes.
- The insurance policy is owned within superannuation with the premium funded solely from Amy’s accumulated benefits.
- The insurance policy is owned within superannuation with Amy funding the premium by salary sacrificing an additional amount of her pre-tax salary so that her employer contributions are increased by the amount of the premium.
- The insurance policy is owned within superannuation with the premium funded by an additional employer contribution equivalent to the amount of pre-tax salary dollars that would have been required to fund the premium in after-tax salary dollars.
Given a marginal tax rate of 41.5 per cent, the additional employer contribution equals: cost of premium ÷ (1 — MTR) = $4,000 ÷ 0.585 = $6,838.
It is worthwhile recognising that the outcomes shown for scenarios 4 and 5 are only relevant to death and TPD cover since an individual is eligible to claim a personal tax deduction for premiums related to income protection cover.
The table below highlights Amy’s net annual income (cash flow), and net annual increase in superannuation benefits (excluding investment earnings), under the five scenarios outlined previously.
It shows that, of the five scenarios, if the focus was to achieve the best outcome in terms of gross cashflow and increase in superannuation benefits, the best approach for Amy would be to salary sacrifice the amount of pre-tax salary that would have been required in after-tax dollars to fund the premium personally (scenario 5).
Scenario 2 provides a marginally better result from a superannuation benefit perspective due to the premium cost providing a tax deduction.
However, if the personal contribution was made to a risk only superannuation policy, no assessable income would exist for the premium deduction to be offset against. In this circumstance, Amy’s outcome under Scenario 2 would be the same as Scenario 1.
Where cash flow is the predominant concern, we find that Scenarios 3 and 4 provide a better outcome.
Under scenario 3, this is simply due to the premium being funded solely from accumulated benefits without making additional contributions.
Under scenario 4, the higher cash flow results because only $4,000 of pre-tax salary is required to fund the premium in super whereas $6,838 of pre-tax salary would have been required to fund the $4,000 premium after deducting 41.5 per cent tax had the insurance been held outside super.
We could also take it one step further by considering a lower income-earning spouse. The primary income earner could look at salary sacrificing further, and then splitting part of their contributions to their spouse’s superannuation to fund their insurance.
Of course, the circumstances of the individual would need to be considered before deciding on the optimal approach from a superannuation benefit and cash flow perspective.
Funding options for insurance should be an important consideration in determining the ownership structure of a person’s life insurance cover, in conjunction with other estate planning factors such as taxation of benefits and beneficiary option flexibility.
Martin Breckon is a technical marketing manager at Aviva.
