When providing insurance advice to clients, a common strategy considered by financial planners is holding insurance in superannuation where possible. There may be various benefits in holding insurance within super which include better cashflow management, making tax-deductible contributions to super to fund insurance premiums and making personal contributions to super to qualify for Government co-contribution and to fund premiums.
Similarly, there may be risks and disadvantages in holding insurance through super, including limitations on terms and type of insurance available, the requirement to meet one of the Superannuation Industry (Supervision) Act (SIS Act) conditions of release before insurance proceeds can be released from super and potential taxation of the payment benefit including insurance proceeds.
While most super products allow holding life, total permanent disability (TPD), and income protection insurance, this article will explain the payment options and considerations of holding a TPD insurance in superannuation.
CLAIMS PROCESS
When holding TPD insurance in super, in the event of a successful claim, insurance proceeds are paid to the super account and allocated to the taxable component.
The client then must meet the SIS Act definition of Permanent Incapacity Condition of Release even if the TPD definition is met for the insurance policy, before accessing insurance proceeds and/or their preserved superannuation benefits.
Under the SIS Act, a member of a superannuation fund or an approved deposit fund is taken to be suffering permanent incapacity if a trustee of the fund is reasonably satisfied that the member’s ill-health (whether physical or mental) makes it unlikely that the member will engage in gainful employment for which the member is reasonably qualified by education, training or experience.
The trustee will generally ask for medical evidence when determining if the member meets the permanent incapacity condition of release. In some limited circumstances, the trustee may use medical evidence provided to the insurer rather than asking to provide new evidence.
If the trustee is reasonably satisfied that the member meets the permanent incapacity condition of release, the payment options include lump sum payment, commencing an income stream regardless of member age and retaining insurance proceeds in superannuation.
There are pros and cons for each of these options and the best option will depend on clients’ circumstances.
LUMP SUM PAYMENT (INSURANCE PROCEEDS PLUS SUPERANNUATION BALANCE)
There may be many reasons why advisers or clients may wish to withdraw the amount as a lump sum. This may include paying off debts, completing modifications to their home or motor vehicle, or to cover medical expenses.
When taking the amount as a lump sum, depending on the clients’ age and the amount being paid, tax may be payable on the amount being withdrawn from the taxable component at a rate of up to 22% (including Medicare levy). However, the Income Tax Assessment Act (ITAA 1997 Act) allows for a formula-based modification of the tax-free component in recognition of the members’ permanent incapacity before reaching the assumed retirement age of 65.
Applying the formula-based modification allows the trustee of the superannuation account to amend existing tax components. As a result of modification, the trustee will increase the tax-free component by the amount calculated and reduce the taxable component accordingly.
Section 307-145 of the ITAA 1997 Act refers to the following formula:
where:
Days to retirement is the number of days from the day on which the person stopped being capable of being gainfully employed to his or her last retirement day (age 65).
Service days are the number of days in the service period for the lump sum (from the start of the eligible service period to the date the disability benefit is paid).
Amount of the benefit is the amount being withdrawn (insurance proceeds and super balance). The calculated amount is then added to the existing tax-free component reducing the balance of the taxable component.
The following case study demonstrates the use of formula-based modification when a lump sum is being paid by the superannuation trustee.
CASE STUDY
David became severely disabled recently. At the time David had $50,000 in super and TPD insurance of $500,000 attached to his super. The insurer assessed and approved David’s application to access TPD insurance and paid the amount to his super account. David wishes to make a lump sum withdrawal to pay off his mortgage.
ASSUMPTIONS:
- David’s date of birth:
- 28 January, 1980;
- Super consisted of $5,000 tax-free and $45,000 taxable components before insurance proceeds of $500,000 were added to the taxable component;
- Eligible service date:
- 6 November, 2001;
- Date David became permanently incapacitated:
- 15 September, 2020;
- Benefit paid date:
- 21 October, 2021; and
- Amount of benefit: $550,000 (super + insurance).
Let’s assume the trustee of David’s super has assessed and approved his application to access the entire balance ($550,000) as a lump sum under permanent incapacity condition of release.
The trustee applies modified calculations as follows: $550,000 x (8,902/16,192) = $302,377
This amount is then added to the existing tax-free component of $5,000 increasing the amount held in the tax-free component from $5,000 to $307,377.
The remaining balance of $242,623 is the new amount in the taxable component immediately prior to the payment. This amount is the difference between the amount of the benefit ($550,000) less the new tax-free component of $307,377. As a result of the modification, the amount in David’s taxable component was reduced from $545,000 to $242,623 providing substantial tax savings to David.
When the lump sum of $550,000 is paid to David, the $242,623 is taxed at 22% ($53,377) as David is below preservation age. David receives a net payment of $496,623.
By applying the modification, the amount paid from the taxable component was reduced from $545,000 to $242,623, and the tax withheld by the trustee was reduced from $119,900 ($545,000 at 22%) to $53,377 ($242,623 at 22%).
CONSIDERATIONS
- The formula-based modification (also known as tax-free uplift) only applies to clients below age 65. Because of the parameters used in the formula, generally, younger clients benefit more from the modification than clients closer to age 65. If we assume David was 10 years older and his eligible service date was 10 years prior to the date used in the case study, with all other parameters remaining unchanged, the new tax-free amount would have been approximately $183,295 resulting in withholding tax of $80,675 and a net payment of $469,325.
- The difference in net payment would have been approximately $27,298;
- The modification is applied to lump sum withdrawals and to rollovers to another superannuation provider. If being rolled over, the modification is applied by the current trustee before the amount is rolled to another provider;
- When calculating the number of days, advisers may use the ‘Calculate Days’ tool available on the Australian Taxation Office (ATO) website;
- An earlier eligible service date reduces the tax-free amount. Be aware of this when consolidating superannuation accounts as the new super fund will pick up earlier eligible service date; and
- Eligibility for Government payments (e.g. Disability Support Pension) to be considered when making a lump sum withdrawal from super as depending on how the lump sum is spent or invested, the amount may now be assessable under the means test.
COMMENCING AN INCOME STREAM
If the trustee of super is satisfied that the member has met the permanent incapacity condition of release, the balance of super (including insurance proceeds) can be used to commence an income stream regardless of members’ age. This pension will commence with unrestricted non-preserved benefits and will not have any limitations on the number of pension payments or lump sum commutations. The formula-based modification will not be applied which means the income stream will commence with tax components as they are.
Investment earnings will be tax-free within the pension account regardless of members’ age. However, pension payments or lump sum commutations may not be entirely tax-free. The proportioning rule will be applied to pension payments where each payment will consist of tax-free and taxable amounts.
If the person is below age 60 at the time of receiving the pension payment, the taxable portion of the pension payment will be added to their assessable income and taxed at their marginal tax rate less 15% offset. Pension payments made after attaining age 60 are tax-free.
CONSIDERATIONS
- The new income stream will be subject to the transfer balance cap;
- Potential impact on Government benefits must be considered as the amount invested in the income stream will become assessable under the means test; and
- Some super providers do not offer an income stream under the permanent incapacity condition of release and as such, the benefit may need to be rolled to another provider in order to commence an income stream.
RETAINING INSURANCE PROCEEDS IN SUPER
Meeting the permanent incapacity condition of release is not a compulsory cashing event. This means the balance of super (including insurance proceeds) can remain in the accumulation account after the member satisfies the permanent incapacity condition of release. In this case, the balance will be made unrestricted non-preserved and future lump sum withdrawals will be available from the unrestricted non-preserved component if/when needed.
However, all future contributions and investment earnings from that point on will be added to the preserved component and the member may need to satisfy another condition of release in the future to make these preserved amounts unrestricted non-preserved.
CONSIDERATIONS
This strategy may be beneficial to people wishing to access Government benefits (e.g. Disability Support Pension) as amounts held in the accumulation account are exempt from the means test until they reach Age Pension age; and
Investment earnings will be taxed at up to 15% in super and that rate may be higher when compared with their personal marginal tax rate. Weighing up and comparing investment earnings tax versus additional Government benefits will be something to discuss with the client to ensure an informed decision is being made.
Anna Mirzoyan is compliance and technical specialist at Lifespan Financial Planning.
