Trauma insurance in SMSFs

Is it time for trustees to reconsider trauma insurance inside a self-managed superannuation fund (SMSF)? Unlike retail or industry super funds, SMSFs have held trauma cover for a long time. Recently the Australian Taxation Office (ATO) issued a draft ruling that confirms that a SMSF holding trauma insurance will not be in breach of the sole purpose test.

What has changed?

The ATO’s draft determination (SMSFD 2009/D1) clarifies when it may be appropriate to hold a trauma insurance policy within a SMSF. The draft determination addresses what trustees should consider when holding trauma inside an SMSF — without falling foul of the sole purpose test.

The sole purpose test broadly limits the provision of superannuation benefits to a range of retirement or retirement-related circumstances. In determining whether to offer trauma insurance, SMSF trustees should consider their obligations to members — as well as factors such as the proportion of contributions applied to purchase insurance cover. An unreasonable diversion of contributions as premiums for trauma cover would be difficult to reconcile with the sole purpose test.

How does a client access a trauma payout?

Where a trauma policy, owned by a SMSF, pays benefits upon the life insured suffering a trauma event, the policy proceeds would be payable to the SMSF. But the proceeds could not be paid to the member until they satisfied a condition of release. Common conditions of release are:

• attaining 65 years of age;
• attaining preservation age and benefits are taken as a transition to retirement pension;
• ceasing a gainful employment after 60 years of age;
• permanently incapacity (a superannuation fund trustee is reasonably satisfied that the member is unlikely, because of physical or mental ill-health, to ever engage in gainful employment for which the member is reasonably qualified by education, training or experience);
• retirement after preservation age;
• temporary incapacity (upon a member temporarily ceasing gainful employment, when the incapacity is not permanent);
• the onset of a terminal medical condition.

Individuals who are unable to meet a condition of release are unable to access their superannuation. The trap is that suffering a trauma condition is not necessarily a condition of release.

Case study 1

Veronique is a 52-year-old company director. She has $150,000 of trauma insurance within her SMSF. She is diagnosed with cardiomyopathy, which is a specified trauma event that triggers a payment to her SMSF. She would like to use the proceeds to pay some of her medical costs. How can she access the payment?

Veronique is under preservation age, which means that her options to access her super are limited. She doesn’t meet a condition of release under temporary incapacity, permanent incapacity or terminal medical illness. The result is that she is unable to access the trauma payment until she satisfies a condition of release.

Are the premiums tax deductible?

Unlike life, TPD (total permanent disablement) and salary continuance cover, trauma premiums are not tax deductible to a superannuation fund. However, concessional contributions such as personal deductible or salary sacrifice contributions could be used to fund trauma premiums — albeit subject to contributions tax in the fund. Even with this result, it can still be tax effective to fund trauma premiums via superannuation, given that trauma premiums are generally non-tax deductible outside of super.

Case study 2

Julie is a 45-year-old self-employed real-estate agent. She runs her business through a company. Juliette is on a salary of $200,000. Superannuation contributions are made by her company to a self-managed superannuation fund.

Julie has death and TPD cover via her SMSF. Julie requires $450,000 of trauma cover and is considering owning that cover either outside of superannuation or within her SMSF.

A trauma policy with a $450,000 amount insured is estimated to cost $2,080 per annum. If the policy were owned outside of superannuation this amount would come from Julie’s after-tax earnings.

If the policy were owned by Julie’s SMSF her company could reduce her salary by the pre-tax equivalent of this amount ($2,080 / 0.535 = $3,887.85) and contribute this amount to superannuation. This would reduce Julie’s after-tax income by $2,080 (the same as the cost of the trauma policy). This contributed amount would be taxable in her SMSF at a rate of 15% ($3,887.85 x 15% = $583.17) leaving $3,304.68 in the fund before the payment of the trauma premium. From this amount the fund could pay the premium on the trauma policy of $2,080, leaving Julie an extra $1,224.68 in the fund.

Alternatively, Julie’s company could pay the superannuation fund just the trauma premium grossed up for contributions tax (ie, an amount of $2,447.05: $2,080 / 0.85 = $2,447.05), while the remaining $1,440.80 is paid to Julie. After tax at a rate of 46.5% this leaves Julie with an extra $770.83 in her hand — compared to her funding the trauma cover outside of superannuation.

Is the payment tax free?

The proceeds of a successful trauma claim are paid as a superannuation benefit. To determine the tax status, you must consider if a superannuation benefit is taxable in the hands of the individual. Taxation will be determined according to the components of the benefit, the age of the recipient, the form of benefit (eg, lump sum or pension) and the condition of release (eg, permanent incapacity/ retirement).

A person who meets the permanent incapacity condition of release and receives a disability lump sum payment may be eligible for an increased tax-free component. Simply suffering a trauma condition will not, therefore, necessarily create a tax-free component.

Within the super fund, the proceeds of a trauma payment will generally not be subject to taxation in the fund and will be allocated to the taxable component.

Summary

Trauma inside super may provide an opportunity for clients to effectively structure their trauma insurance, and provide advisers with an opportunity to talk to their SMSF clients about another topic rather than investment performance. The strategy is not appropriate for all clients, and poor advice may result in a trauma payment being locked inside super. Good advice ensures that the strategy aligns with the client’s situation and reduces the risk of a successful claim being locked inside super.

Troy Smith is a technical specialist at ING Australia.