Total and Permanent Disability (TPD) insurance inside and outside superannuation

Jul

Total and Permanent Disability (TPD) insurance inside and outside superannuation

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Many people consider whether they should own their TPD policy individually (self-owned) or have it be structured via a superannuation fund where they are a member.

This article, reproduced with permission by MetLife Insurance Limited (Metlife) in June 2020, considers this further.

So that we are comparing “apples with apples”, we will assume that the policies being considered in the examples below are TPD policies that would meet the common “any occupation” definition, and thus also meet the permanent incapacity definition condition of release under the Superannuation Industry (Supervision) Regulations, superannuation disability benefit , and the definition of compensation for injury or illness.

Deductibility of premium payments by the individual

First, where the life insured owns a TPD policy on their own life (outside super), the life insured may not claim a tax deduction for the premiums paid. This means that the premiums are paid in after-tax dollars. For an individual who is on the highest marginal tax rate, this means that they must earn $1,886.79 in order to afford a $1,000 premium.

Where the life insured has structured a TPD policy so that it is owned by the trustee of the superannuation fund where they are the member, depending on how they then pay for premiums, they may be cheaper due to potential tax deductions:

If the member pays the premium with non-concessional contributions, then the net result to the life insured is no different if they are on the highest marginal tax rate – they will need to earn $1,886.79 in order to pay for a $1,000 premium.
Where a member makes a concessional contribution to the fund, this will normally attract contributions tax except where the contribution is used to pay for an insurance premium. In order to pay a $1,000 premium in a superannuation fund, a member can make a $1,000 concessional contribution, and claim a tax deduction at their marginal tax rate, effectively paying $530 if the member is on the highest tax rate.
A third alternative is where a member chooses to rollover the amount of the premium from a superannuation fund where they are an existing member, to a different superannuation fund where their life insurance is owned by the trustee – in this circumstance the member is not entitled to a tax deduction.

What is the impact of each of these scenarios at claim time ?

First, where a life insured owns a policy on their own life (outside super) and they are also the beneficiary of the policy, then the TPD benefit will be paid from the life insurance company to the life insured tax free. It will also be paid tax free if the TPD benefit is paid to a defined relative. If the TPD benefit is paid to somebody who is not the life insured or a defined relative, then the benefit will normally be treated as a capital gain to the recipient. The gain will be the sum insured less any premiums paid, and may be subject to capital gains discounting if the policy has been held for more than 12 months.

For the case where the life insured purchased a policy with a sum insured of $1 million, if he becomes totally and permanently disabled, then he will receive a TPD benefit from a life insurance company of $1 million (subject to meeting the terms and conditions of the policy).

Second, if the life insured has structured the policy so that it is held by the trustee of a superannuation fund where they are a member, then it becomes far more complicated. In the first instance, expect to pay some tax. The tax may be as little as nil or may be as much as 20 per cent (plus Medicare levy). The variables that influence the rate of tax are numerous: sum insured; age of life insured at date of disablement; date the money is withdrawn from the fund; when the life insured became a member of the fund; if the life insured rolled-in a pre-service period; and years to retirement.

If the same life insured, let’s call him Fred, was to have the same $1 million sum insured in an insurance only superannuation fund (no accumulated assets) and then became totally and permanently disabled, how much tax would be withheld by the superannuation trustee ?

Example 1

If Fred joins the fund at age 18 and suffers a terrible accident the day after he joins the fund, where he is totally and permanently disabled, then the calculation would look like this:

TPD payment from insurance company to superannuation fund = $1,000,000

Tax free amount modification for disability benefits = sum insured x (days to retirement/(service days + days to retirement)) = $1,000,000 x (17,154/17,155) = $999,941

Taxable component = $1,000,000 – $999,941 = $59

Tax on taxable component = $59 x 20%* = $11

Net benefit paid to member = $1,000,000 -$11 = $999,989

(* – Does not included Medicare Levy).

Example 2

If Fred joins the fund at age 18 and suffers a terrible accident at age 56 (prior to preservation age), where he is totally and permanently disabled, then the calculation would look like this:

TPD payment from insurance company to superannuation fund = $1,000,000

Tax free amount modification for disability benefits = sum insured x (days to retirement/(service days + days to retirement)) = $1,000,000 x (3,285/17,155) = $191,489

Taxable component = $1,000,000 – $191,489 = $808,511

Tax on taxable component = $808,511 x 20%* = $161,702

Net benefit paid to member = $1,000,000 – $161,702 = $838,298

(* – Does not included Medicare Levy).

Example 3

If Fred joins the fund at age 18 and suffers a terrible accident at age 59 (after preservation age), where he is totally and permanently disabled, then the calculation would look like this:

TPD payment from insurance company to superannuation fund = $1,000,000

Tax free amount modification for disability benefits = sum insured x (days to retirement/(service days + days to retirement) = $1,000,000 x (2,190/17,155) = $127,659

Taxable component = $1,000,000 – $127,659 = $872,340

Tax on taxable component = ($872,340 – $210,000) x 15%* = $99,351

Net benefit paid to member = $1,000,000 – $161,702 = $900,649

(* – Does not included Medicare Levy).

Example 4

If Fred joins the fund at age 18 and suffers a terrible accident at age 62 (after preservation age), where he is totally and permanently disabled, then the calculation would look like this:

TPD payment from insurance company to superannuation fund = $1,000,000

Tax free amount = After age 60 all benefits released from super to the member are tax free

Tax on taxable component = NIL

Net benefit paid to member = $1,000,000

Example 5 (nasty sting in the tail)

If Fred joins the fund at age 50 and suffers a terrible accident at age 56 (prior to preservation age), where he is totally and permanently disabled, then the calculation would look like this:

TPD payment from insurance company to superannuation fund = $1,000,000

Tax free amount modification for disability benefits = sum insured x (days to retirement/(service days + days to retirement) = $1,000,000 x (3,285/5,475) = $600,000

Taxable component = $1,000,000 – $600,000 = $400,000

Tax on taxable component = $400,000 x 20%* = $80,000

Net benefit paid to member = $1,000,000 – $80,000 = $920,000

(* – Does not include Medicare Levy).

This assumes that Fred pays his premiums by concessional or non-concessional contributions. If Fred pays his premiums by a rollover from a fund where he was a member from age 18, then the calculations are not quite so advantageous.

TPD payment from insurance company to superannuation fund = $1,000,000

Tax free amount modification for disability benefits = sum insured x (days to retirement/(service days + days to retirement)) = $1,000,000 x (3,285/17,155) = $191,489

Taxable component = $1,000,000 – $191,489 = $808,511

Tax on taxable component = $808,511 x 20%* = $161,702

Net benefit paid to member = $1,000,000 – $161,702 = $838,298

(* – Does not included Medicare Levy).

This results in the member receiving $81,702 less because the premium was paid via a rollover.

Is it possible to reduce the tax impact ?

Is there any way for Fred to reduce the tax to nil? Yes, but it may be difficult for many people to facilitate. The member of the superannuation fund would need to make a non-concessional contribution to the superannuation fund PRIOR to the superannuation trustee releasing the benefits from the fund to the member. In this example, we are going to change the parameters. The sum insured is being reduced to $400,000, and the member of the superannuation fund has made a non-concessional contribution of $300,000 some time prior to the trustee releasing the TPD benefits to the member.

If Fred joins the fund at age 50 and suffers a terrible accident at age 56 (prior to preservation age), where he is totally and permanently disabled, then the calculation would look like this:

TPD payment from insurance company to superannuation fund = $400,000

Non-concessional contributions made to the fund still in accumulation phase = $300,000

Assume there are no earnings in the fund.

Tax free amount modification for disability benefits = (sum insured + non-concessional contributions) x (days to retirement/(service days + days to retirement)) = ($400,000 + $300,000) x (3,285/5,475) = $420,000

Tax free component = Tax free amount modification for disability benefits + non-concessional contributions = $420,000 + 300,000 = Revised to $700,000* ($720,000)

Tax on taxable component = (amount of benefit – tax free component) x 20% = ($700,000 – $700,000) x 20%* = NIL

Net benefit paid to member = $700,000 (including non-concessional contributions)

(This assumes that Fred pays his premiums by concessional or non-concessional contributions).

Are there any other alternatives ?

Yes, the life insured could begin to receive an income stream that is taxed at the member’s marginal tax rate less a 15% tax offset, until the member turns 60, after which time the income stream is tax free.

Otherwise if the member delays receiving the TPD payment (i.e. – lets the TPD insurance benefit remain in the super fund) until after the member turns age 60, then the lump sum would be tax free.

Summary

When it comes to TPD insurance, deciding whether to hold insurance inside or outside of superannuation will depend on each person’s individual circumstances.

When it comes to holding TPD insurance inside superannuation, it may be nice to receive a tax deduction for paying TPD premium via a concessional contribution to superannuation, or it may be convenient to simply rollover money from another super fund to pay for a premium. Both situations have different tax implications for a member who has a successful TPD claim paid from a trustee of a superannuation fund.

Alternatively, owning a TPD policy outside of superannuation results in no tax deductions for the premiums, but also results in no tax liability at claim time.

The information above contains general information only and does not take into account your personal situation, needs or objectives. Before deciding whether to acquire, or continuing to hold, any insurance or superannuation product, please read the PDS available.

Information is current at June 2020 and subject to change.

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