The new super rules have advisers questioning if it is still prudent to hold insurance inside an SMSF. Tim Miller analyses some advantages of such a strategy that make it worthy of consideration.
We all know SMSF trustees are under an obligation to consider the insurance needs of the members and document this as part of the fund’s investment strategy. With the restriction of non-concessional contributions being linked to an individual’s total superannuation balance and a limit on how much money can be used to commence a pension, what does the future hold for insurance inside super?
Insurance is always a contentious issue because we are effectively acquiring something that we may never use and under certain scenarios may never see because the realisation of a policy may be subject to our own death.
In the scheme of planning for retirement and indeed supporting our partner or families once we pass away, or are unable to work due to disability, insurance could very well play a bigger part for many members in the future than it does now.
Part of contemplating insurance is the need to factor in how much money the family will need once a member passes away or is unable to work due to disability.
If we start with the $1.6 million as our base number for paying a retirement income to a member when they turn 65, is that enough to support the family if a member passes away before the age of 65? How long will their spouse live for? Alternatively, if the member becomes permanently incapacitated, will this amount be sufficient to meet their living expenses, which now may incorporate family home modification? These are the questions there are no definitive answers for as everyone’s circumstances are different.
Not just an income stream
Insurance in super should no longer be considered primarily as an income replacement strategy. At the very least for many it is for debt removal, but if used properly it could be part of an extremely useful tax relief strategy. The introduction of the transfer balance cap requires a major rethink of why we hold insurance in an SMSF as the payment of a disability superannuation income stream or a death benefit income stream as a result of our own early retirement due to incapacity or death while still working means we may lock in a lower personal transfer balance cap for ourselves, or our spouse, than we would otherwise desire. The above doesn’t mean we shouldn’t hold insurance inside our SMSF, it just means we need to be more considerate of what we do with insurance proceeds. Disability and terminal illness are two conditions of release we’d all like to avoid, but when they become unavoidable what can we do with the proceeds? Should we look at the opportunities lump sums provide?
One of the anomalies of the transfer balance cap is the exclusion for structured settlement/personal injury contributions, but the inclusion of total and permanent disability proceeds within the $1.6 million cap and subsequent entitlement to earnings exemption within the retirement phase. It means in effect structured settlement contributions are uncapped and therefore entitled to far more generous earnings exemption potential. Excluding these contributions is a very sound measure, but it also means the law looks more favourably on people taking legal action against an employer rather than holding an insurance policy in the event of an accident at work. Rather than bemoan the issue, let’s consider the options available.
Should we cease work, or be unable to work due to injury or illness, there are still some benefits we should consider specifically with regards to holding insurance via an SMSF.
Firstly the premiums are deductible, which helps reduce the 15 per cent tax liability on the contributions made to maintain the premium payments. Secondly, in the event we are deemed permanently incapacitated for condition of release purposes, there is a high chance we will meet the disability superannuation benefit requirements and as such entitle ourselves to a modification of the tax-free portion of our benefit payment.
For those starting out in the workforce and super system, this can be quite a significant modification. The modification effectively reassigns the portion of any benefit that represents our total days to retirement (at age 65) from the date of disablement over our total service period. For younger members, or members with a small service period, this can be significant. For those under preservation age it means turning taxed money into tax-free money. The taxed element of a fund is taxed at 20 per cent plus Medicare under preservation age when unrestricted non-preserved benefits are taken as a lump sum. If, on the other hand, we choose to take a pension from disablement, we trigger our transfer balance cap, generating exempt pension income on up to $1.6 million and then our income is subject to tax with a 15 per cent rebate. Therefore, we should discount the opportunity of taking a lump sum over a pension as there can be significant tax benefits for both.
Modification for disability lump sums
The calculation to modify the tax-free amount when paying a disability lump sum is based on the following formula:
Amount of benefit x days to retirement
–––––––––––––––––––––––––––––––
service days + days to retirement
Days to retirement are the number of days from when the member was no longer capable of being gainfully employed until their last retirement date – their 65th birthday. Service days are the number of days of service.
Tax-free modification calculation example
Simon commenced work on 1 March 1995 and due to an accident ceased work on 31 March 2017. Simon turns 65 on 1 October 2040. His balance, including insurance, is $1.5 million, including a tax-free amount of $450,000. He wishes to take $300,000.
Step 1 – calculate the normal tax-free amount of the benefit immediately before it is paid. $450,000/$1,500,000 = 30%
$300,000 x 30% = $90,000
Step 2 – calculate the modified tax-free amount of the benefit using the formula.
Days to retirement are 8585 and total service days are 16,652
$300,000 x 8585/16,652 = $154,666
Step 3 – add Step 1 and 2 together: $154,666 + $90,000 = $244,666
Step 4 – work out the taxed component: $300,000 – $244,666 = $55,334
Step 5 – calculate tax on taxed component: 22% x $55,334 = $12,173
Therefore, because Simon can access his benefit and modify the calculation, he saves $34,027 tax.
Note: Even if Simon did not have any tax-free amount to start with, he would still receive the $154,666 tax-free amount, saving that tax.
In the above example, if Simon elected to take his entire balance of $1.5 million then the modified tax-free amount would be $1,223,330 and his tax liability would be around $60,000.
For many the choice to take a lump sum will be attractive, although appropriate advice should be sought.
Where the real benefit may lie is with the fund. In the event a member is in receipt of a disability superannuation benefit that was subject to an insurance policy, the fund may be able to claim a deduction for the future liability to pay a benefit under section 295-470 of the Income Tax Assessment Act 1997.
Deduction for the future liability to pay a benefit
Section 295-470 allows a fund to claim a deduction on payment of:
- a superannuation death benefit, or
- a disability superannuation benefit, or
- a terminal illness benefit, or
- a temporary incapacity income stream.
The payment of a), b) or c) must be as a consequence of termination of a member’s employment and the deduction is available for the payment in the form of a pension and/or a lump sum.
The formula for calculating the deductions is as follows:
Benefit amount x future service days
–––––––––––––––––––––––––––––
total service days
Benefit amount is the lump sum or the purchase price of the pension or the total of the amounts paid during the income year in the instance of a temporary incapacity income stream.
Future service days are the number of days from the date of termination to the member’s last retirement day (at age 65).
Total service days are the sum of future service days plus the member’s eligible service period to the day of termination.
Prior to claiming a deduction under section 295-470, the fund must make an election under section 295-465(4) not to deduct amounts based on the premiums paid, but rather to claim on the future liability to pay benefits.
The election applies to all future years unless otherwise determined by the tax commissioner. Therefore, if a fund elects in the year of paying a benefit to claim for future liability and not for premiums paid, it cannot in future years claim insurance premiums for other members of the fund. The fund can claim the premium-based deduction up to the year the benefit is paid and make the election then.
This requirement makes the future liability deduction more attractive to an SMSF as the deduction attributable to individual member premiums will in most instances be less significant.
Deduction example
Let’s look at Simon’s case again. He is 41 and currently has $1.5 million in his fund and, as a result of his disability, decides he can take either a lump sum or a pension. If he commences a pension, he will have used 93.75 per cent of his personal transfer balance cap, meaning when he gets to retirement age he will have very little scope to contribute more towards a pension. What if he elects to draw his entire benefit as a lump sum? Step 1 – calculate the future liability to pay a benefit deduction using the formula.
Future services days are 8585 and total service days are 16,652
$1,500,000 x 8585/16,652 = $773,330
Step 2 – Simon’s SMSF claims a tax deduction for $773,330.
Losses created by this deduction can be carried forward.
Granted that Simon has paid about $60,000 to take this lump sum, he will have the ability to make future concessional contributions without the associated tax liability. That is, he could contribute the maximum each year until preservation age then commence a pension and ultimately not pay tax again in the fund. Of course, we can add the contributions his wife is making at the same time.
Just as with the disability lump sum, the deduction will be significantly higher the longer the period to retirement is.
While the fund is not generating exempt income as there is no pension, it is effectively removing its taxation liability for a certain period and at the same time preserving all members’ transfer balance cap. The downside is the fund can no longer claim a deduction for any further premiums it pays for other members, but if the benefit payment is significant, and this is matched in significance by the deduction, then the loss of the annual premium deduction may prove minor.
Given the deduction can be claimed for death benefits and terminal illness benefits, neither of which are taxable in the lump sum environment (paid to dependants), this insurance-based deduction should be front of mind in the unfortunate event something happens to a client pre-retirement age.
