Tips and traps of funding insurance premiums
Once your client recognises the need for insurance to secure their future, you can discuss which strategies are best and whether the insurance should sit within or outside of superannuation.
In this article, we look at two hypothetical situations which often lead to unintended consequences, highlighting the importance of clients getting in contact with advisers before such decisions are made.
Service period and the impact on taxation of a disability lump sum
Let’s say that after considering his objectives, financial situation and needs, you gave advice to your client, John (30), that he needs $660,000 TPD cover through his current super policy (a taxed super fund), providing him with a net benefit of approximately $650,000. At the point of providing advice, the need is to provide a net benefit of $650,000. Based on this, the required level of insurance is determined to be $660,000. The net benefit may change over time, and may need to be addressed via the review process.
In formulating the amount, you considered that upon successful payout of the TPD amount, the insurance proceeds will be taxed as a superannuation benefit. John (being under preservation age) will need to pay 20 per cent plus Medicare levy of 2 per cent on the taxable component. Over time, the proportion of increased tax-free component will reduce, hence more tax payable.
You recognised that the tax position on any future lump sum changes as time goes on, therefore the insured amount must be regularly reviewed given the changing proportion of tax components and net benefit amount going forward.
Where a disability super benefit is paid as a lump sum, the tax components of the benefit are recalculated to provide an additional tax-free component to compensate the individual for the number of years they could not work to age 65 based on the following:
Days to retirement: is the number of days from the day on which the person stopped being capable of being gainfully employed to the last retirement day (usually 65 unless an earlier day is nominated in the employment contract).
Service days: is the number of days in the service period for the lump sum, commencing from the start date for the super fund. The start date is the earlier of commencement date of the super plan, the start date of any employers that have contributed to the fund, or the start date of any roll-overs into the fund.
John’s current days to retirement are 35 years (12,784 days) and his service period is 2 years (730 days).
You quantified John would receive the following net benefit amounts if the TPD event happened at the following ages. These amounts have been calculated applying 20 per cent tax plus Medicare levy on the taxable component. John’s existing tax-free component is nil; however, the above calculation has been used to calculate a tax-free component due to this being a disability lump sum payment.
What if John does a roll-over to his existing fund containing TPD cover?
John has a small super balance of $300 in another super fund when he did vacation work during the school holidays going back 15 years ago. Upon receiving marketing information regarding consolidation from his current super fund and without seeking advice, John consolidates his superannuation accounts.
Due to the roll-over, John’s service period has increased from 2 years (730 days) to 15 years (5478 days). This has an effect on any subsequent recalculation of the additional tax-free component.
As we can see from the above table, the roll-over with the earlier service period has resulted in relatively lower net TPD benefits (except age 60 where the lump sum is received tax-free). Due to the formula above, an earlier service period results in a lower tax-free component, higher taxable component and increased tax payable (prior to age 60). The above table reinforces the importance of service period and highlights that a lower service period is favourable for clients receiving lump sum disability withdrawals.
It is important to educate clients that they should contact their advisers prior to redirecting super contributions or consolidating super accounts to ensure that there are no unintended consequences.
Incorrect coding of contributions
Care must be taken to ensure that contributions are classified correctly.
In the case of a sole trader, we have seen many situations where they would incorrectly view their contributions as employer contributions when they should have been classified as personal member contributions. Often the intention is to claim a tax deduction for these personal member contributions, subject to eligibility requirements being met.
Left unaddressed, the member may miss out on claiming a tax deduction on their personal super contributions due to not providing the fund with a valid Notice of Intent to claim a tax deduction (NOI) documentation within the required time frames.
What if John wants to fund his premium by making personal member contributions and claiming a tax deduction?
John is a sole trader and intends to fund his $1,000 insurance premium by making personal member contributions and claiming a tax deduction. Upon electronic instructions to his super fund, he unfortunately reflects these contributions as employer contributions. His accountant does not ask for a NOI, nor the acknowledgement letter provided by the superfund, and completes John’s tax return, including claiming a deduction for the $1,000 contribution.
The ATO receives the member contribution statement from the super fund showing no member contributions (because it was reflected as employer contributions) and denies the $1,000 deduction. This could have been avoided had John correctly classified his contribution from the outset as a personal member contribution and then provided a NOI to his super fund confirming his intention to claim a tax deduction. Or if the issue had been picked up before his tax return was done, he could have requested his super fund to correctly classify the contribution and submitted his NOI to claim a tax deduction.
Holding insurance inside super can be advantageous but it is important that as an adviser, you have an understanding of the implications. Equally, it is important that you educate your clients. At the very least, clients should be aware that they need to engage their adviser before doing anything that could impact the super fund (including rolling over benefits, redirecting or changing super contributions).
Be sure to have a discussion around insurance through super with your clients in your next meeting.
Rahul Singh is a technical services manager with ANZ
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