Andrew Biviano explains the benefits of selecting TPD insurance through superannuation and outlines the different options available to clients looking for cover.
Having total and permanent disablement (TPD) insurance within a superannuation fund can be a tax-effective way to cover the cost of premiums. However, in the event of a claim, it is important that the payment options and the tax consequences of those choices are known.
Importantly, it is worth noting the requirements under the Income Tax Assessment Act 1997 (ITAA) for the tax benefits associated with a disability benefit are slightly more onerous than the superannuation preservation requirements detailed within the Superannuation Industry (Supervision) Regulations 1994 (SISR).
Both generally require a person to suffer from ill-health (physical or mental) and be unlikely to ever be gainfully re-employed in a capacity for which they are reasonably qualified by education, experience or training.
The key difference is under SISR, the trustee is required to be of that opinion, however, under ITAA two medical practitioners must be of that opinion — in practice though many trustees require two doctors’ reports as part of their decision process.
Payments options
Where a superannuation fund member becomes eligible and meets both the tax and super definitions to be eligible to receive a disability benefit, they generally have the option of a lump-sum and an income stream.
In the case where the member decides to take a lump-sum, the tax-free amount is adjusted to acknowledge the future years until age 65 for which the member will be disabled. To do this, Formula 1, as prescribed by ITAA section 307-145, is used and then added to the current tax-free amount.
To help illustrate this benefit, consider the following case studies.
Case Study 1
Bill is aged 45, has $300,000 in a taxed super fund ($20,000 tax-free and $280,000 taxed component) with a death and TPD benefit of $500,000 (which includes insurance proceeds of $200,000). If Bill’s current service period is 20 years and future service until age 65 is 20 years, what amount of tax will be payable if he became totally and permanently disabled today? See Formula 2.
The taxed component — calculated by subtracting the tax-free amount from the lump sum amount — is $230,000 ($500,000 — $270,000). This means Bill’s tax liability, using the table below, is $46,000 plus Medicare Levy ($230,000 x 20 per cent).
Case Study 2
Assuming the same superannuation disability benefit and components, if Bill has attained his preservation age and his current service period is 30 years, leaving 10 years of future service, we will get the results shown in Formula 3.
This leaves a taxable component of $360,000 ($500,000 — $140,000), with a tax liability of $31,500 plus Medicare Levy [($360,000 — $150,000 Low Rate Cap) x 15 per cent].
On reviewing Case Studies 1 and 2, we note as Bill ages the modified tax-free amount reduced. However, the concessional tax treatment on attaining preservation age provides some relief.
Another point to note when comparing the case studies is that the service days and days to retirement are the same and as Bill gets closer to retirement the fraction of future service over total service (ie, current plus future services) reduces.
Alternatively, let’s consider the effect in each of the previous cases where Bill’s current service period (days from eligible service date to date of disablement) is reduced to, say, five years.
Case Study 3
Assuming Bill’s superannuation and future service is the same as Case Study 1 but his current service period is reduced to five years, his tax-free component will be $420,000 ($20,000 + ($500,000 x 20/25). This leaves a taxable component of $80,000 with a tax liability of $16,000 plus Medicare Levy.
Case Study 4
Assuming Bill’s superannuation and future service is the same as Case Study 2 but his current service period is reduced to five years, his tax-free component will be $353,333 ($20,000 + ($500,000 x 10/15). This leaves a taxable component of $146,667, with a tax liability of nil as it is under the low rate cap.
In summary, Case Studies 3 and 4 emphasise the positive impact a shorter current service period can have on the calculated tax free component for a disability benefit paid as a lump sum, which in turn means a significant increase in Bill’s net benefit when compared with the original case studies.
From a planning perspective, whilst a client’s work history cannot be shortened, the service period within a fund that holds a client’s superannuation benefit can be shortened. In practice, this may mean considering:
- whether the client will benefit from holding their insurance in a new fund rather than their existing fund;
- the impact of consolidating superannuation benefits from a fund with an earlier eligible service date into the super fund that holds the client’s insurance benefits; and
- whether the current level of insurance is sufficient after tax to cover its intended purpose.
As noted previously, where a disability benefit is taken as an income stream, the tax-free modification formula under ITAA section 307-145 does not apply.
In this case, the standard superannuation proportioning rules are used to establish the disability income stream.
Importantly, the money invested within the income stream will be unrestricted non-preserved, thereby allowing capital drawdowns to be taken as required and for investment earnings to be tax-free within the fund.
Pension payments received by a member (which must meet the minimum requirements) from a disability income stream as described in the table (see left) will be taxed at their marginal tax rate (MTR) with a tax rebate of 15 per cent on the taxed component (taxed element) where they are under age 60 or tax-free where they are aged 60 or over.
Andrew Biviano is technical services and paraplanning manager at Fiducian Portfolio Services.
