Challenging Life Insurance for SMSFs
Legislative changes confuse 500,000 insured Australians using self-managed superannuation fund. Still, huge growth in SMSF retirement savings continues. Hence, TAL’s David Glen said clients and advisers must work together to determine what would provide best for life insurance needs: SMSF, retail superannuation or outside superannuation.
Thorough knowledge on SMSF use in investment and tax planning is important as client circumstances vary. Without knowledge, clients may miss the chance to use life insurance within SMSF for estate planning.
The Lump Sum Approach
Lump sum payment is possible via SMSF life insurance in case of an insured’s death which may be used as seed capital for a testamentary trust for the beneficiaries. This may remain under the testamentary trustee’s control who distributes it to the beneficiaries as needed.
- This benefit paid to the spouse or financially dependent child is tax-free.
- The testamentary trust earning is taxed at individual rates.
- Penal rates for passive income earned by minors do not apply on testamentary trust earnings.
- Death benefits for non-dependant beneficiaries like adult children are taxable.
- Tax is formula-based and factors like service and future service periods determine the payable amount.
- SMSF clients may provide the required cover outside or within superannuation. The non-dependant beneficiary may gross up the insured amount to cover tax payables.
The Pension Approach
Surviving spouses and dependants may opt for pension strategy via the SMSF and life insurance policies.
- SMSF on investment supporting pension income is tax-free but income in excess of $100,000 per annum in a superannuation fund is taxed 15%.
- Taxes apply on below age 60 pension recipients but will qualify for the 15% and possibly the low income rebate. This could mean a pension payment of about $46,000 per annum at present rates minus taxes.
- Life insurance in retail fund is possible and SMSF may be used for retirement savings.
- The Superannuation Industry Supervision (SIS) Rules allow a lump sum death benefit to be rolled over to an SMSF to pay the benefit in pension form.
SMSF TPD Cover Types
- 1. Own vs. Any Occupation
Own occupation, just like any occupation cover, pays a claim when the member becomes unable to perform occupational duties. However, it is more extensive than any occupation cover.
TPD cover in super is limited to any occupation only and clients with SMSFs are generally in the higher income bracket thus they prefer the own occupation cover.
- 2. TPD Inside/Outside Super
TPD in super may finance the cover cost via tax deductible contributions, or salary-funded employer contributions while cost of TPD cover outside super is not deductible in general. TPD in super may be tax efficient but has other issues like compliance.
TPD cover choices for SMSF member include cover within super, outside super or through one of the market’s linked products. Linked products offer any occupation cover held within SMSF and own occupation held outside super.
- TPD cover funding via own or any occupation is the most tax effective where cover cost is financed through tax deductible contributions within super funds.
- Contributions are taxed 15% but may be reduced to 0% through premium tax deduction benefit.
- Any occupation in super fund may enjoy tax deduction up to 2/3 of the premium where the remaining non-deductible 1/3 is attributable to the own occupation component.
- Portion of the own occupation cover is subject to contributions tax.
- Contributions funding own occupation cover may be grossed up for sufficient funds.
Own occupation component is $0.33 for every dollar of premium paid hence member has to contribute $0.388 into the superannuation fund to finance it. Contributions tax on this is $0.058 leaving $0.33 after tax to fund the own occupation component of the insurance. The TPD cover under this structure costs $1.06 in each $1 of premium payable.
Outside superannuation, member pays tax at the maximum marginal rate of 46.5% and has to shell out $1.86 to finance every $1 premium with a $0.86 tax. After tax, $1 remains to fund the premium.
Factors that Affect TPD Cover in Super
- Risk of trapping own occupation benefit in the superannuation system when client does not meet release conditions despite valid claim under the insurance contract.
- Contributions funding the TPD insurance count toward the member’s concessional contribution caps.
- The benefit may be taxed in the member’s hands on payment unless paid to those aged 60 and beyond for benefits in super.
Draft regulations coming from the government may affect TPD arrangements and clients may need to effect their cover before 1 July 2013. There may also be a need to opt for split products that would help clients avoid claims issues.
Options for SMSF Clients
- Financially stable SMSF clients should consider taking income protection insurance outside superannuation.
- Income protection in super delivers the same result for the SMSF member.
- Outside super, income protection premiums are generally tax deductible, the claim proceeds treated as assessable income.
- Premium funds through super are deductible or may be funded from pre-tax income via a salary sacrifice.
- Under both options, the premium after-tax cost and claim proceeds tax treatments are the same.
Clients face more compliance issues in income protection within super such as the Temporary Condition of Release. Also, there is no ancillary benefits range of offers available. Some injuries are also not authorized by the Conditions of Release.
SMSF members with cash flow issues may not find enough advantage in income protection within super. They may fund their cover by using their accrued superannuation benefits and contributions made under the Super Guarantee Provisions.
Being unaware of how life insurance provisions on premium deductibility and claim proceeds work may pose problems. Advisers need to provide the best opportunity for clients where income protection is concerned that is cost-effective based.