If it has been a while since you’ve reminded your clients about the need to review and update their SMSF investment strategy, now is probably a good time to do so. Not doing so could leave the fund open to the new Australian Taxation Office (ATO) penalty regime, which could impose a fine of up to $11,000.
In summary, from 7 August 2012 new regulations came into effect requiring an SMSF trustee to consider whether they should hold a contract of insurance that provides insurance cover for one or more members of the fund as part of the fund’s investment strategy. In addition, new rules were also introduced that now explicitly state trustees must regularly review the fund investment strategy.
In order to support compliance with these new rules, it is important the trustee is able to show they have considered the insurance need for each member and documented it as part of the fund’s investment strategy and/or documented it within trustee minutes held during the financial year.
As detailed in the explanatory memorandum supporting the new regulations, compliance with the new regulations will require a trustee to have regard to the personal circumstances of members and other legislative requirements, including the sole purpose test. Further guidance on the type of insurance that needs to be considered can be found within additional Stronger Super regulations being proposed as part of the insurance and MySuper consultation. In essence, the proposed changes seek to limit the type of insurance benefits a trustee can provide to members from 1 July 2013 to those capable of satisfying the condition of release for death, terminal illness, permanent incapacity (based on the reasonably qualified by education, training or experience definition) or temporary incapacity.
Accordingly, in order for a trustee to show compliance with the new regulations, they will need to review the information collected from a member on entry and as part of the year-end review process to show they have considered a member’s life, total and permanent disablement (TPD) and income protection needs.
Practically though, will this require a trustee to show they have considered the members’ insurance needs by undertaking a review of each member’s assets and liabilities, income and expenses, the type and level of insurance they already hold, so that they can form a valid opinion? Or will it be sufficient for the trustee to form their opinion and show that it has been considered by asking the member about the type of insurance they currently have in place, whether the member feels it is adequate and why, and if not, whether they would like it to be reviewed? From my perspective, either option may be sufficient, however, where the initial method is used, care must be taken to ensure personal insurance advice is not provided, unless the trustee is appropriately qualified to do so.
Important consideration
Putting aside the legislative need for insurance, personal risk insurance is fundamental to protecting a person’s wealth, their ongoing ability to maintain a wealth-creation strategy and to help protect and maintain a certain standard of life should an insurable event occur.
However, like with most investment decisions, there are always advantages and disadvantages that need to be considered. The following points highlight some of the advantages associated with holding insurance within super:
- In some cases a lower net cost as insurance premiums for life, TPD and income protection are tax deductible to the trustee, as long as they are used to pay out a superannuation death benefit, terminal illness benefit, a disability benefit or a temporary incapacity benefit.
- Pre-tax contributions (salary sacrifice and personal deductible amounts) can be used to pay a premium, which also helps to reduce the amount of gross income used to pay for insurance.
- Accumulated superannuation money, along with compulsory superannuation guarantee amounts, can be used to help cover any insurance premiums, reducing the impact premiums have on the client’s cash flow.
- Where eligible, a non-concessional contribution made to super to cover insurance premiums qualifies for the government co-contribution.
- Using a spouse splitting strategy (split up to 85 per cent of the concessional contributions made in the previous financial year) to help pay the insurance premiums for the member’s spouse allows:
- A member who has exceeded the concessional contribution cap to use an eligible spouse’s concessional contributions to help cover their insurance premiums.
- The spouse who receives the greatest after-tax benefit from salary sacrifice to maximise the amount contributed and then split this with an eligible spouse to cover insurance premiums.
In contrast, some of the disadvantages are:
- Not all types of personal insurance satisfy a condition of release allowing a benefit to be paid to the member.
- Policies generally come with fewer features due to the legislative requirements.
- Superannuation rules limit who can be paid a death benefit. This, combined with the need to ensure you have a valid binding nomination in place to avoid trustee discretion being exercised, may mean proceeds are not paid to the intended person. As described in Katz v Grossman [2005] NSWSC 934 and Donovan v Donovan [2009] QSC 26, these issues also impact on SMSFs notwithstanding that members are generally related.
- Superannuation savings will be reduced by premiums where additional contributions are not made. Conversely, where contributions are made, then care must be exercised to ensure contribution caps are not exceeded.
TPD proceeds and death benefits, in certain cases, are taxable when received instead of being able to be received tax free as is the case with comparable self-owned policies outside of superannuation. This is explored further in the following section.
Tax and payment options
Another key consideration is ensuring the right person can benefit from any insurance proceeds and extra tax is not being paid needlessly.
In general, where insurance is held outside of superannuation, the policy holder, not the insured, nominates the beneficiary, the person who will benefit from any insurance payment. In cases where no beneficiary is nominated, insurance proceeds are generally paid to the policy holder or their estate in relation to a term life policy. From a tax perspective, where the person receiving the payment is the insured, or a defined relative of the insured, then proceeds for life and TPD are 100 per cent tax free, whereas any income protection policy proceeds are taxed at normal marginal tax rates.
Where insurance is held in super, the policy owner is the trustee, with the member being the insured. Superannuation law and the fund’s trust deed provide the framework regarding payment procedures and options, which then are subject to various tax laws that take into consideration the payment type and the recipient of the proceeds.
Income protection
When an income protection policy is held within superannuation, any benefits are paid to the member and taxed at their marginal tax rates. From a condition of release perspective, it is important to note that Schedule 1 of the Superannuation Industry (Supervision) (SIS) Regulations limits the amount a member can receive to an amount not more than their pre-disability income. Therefore, in cases where the temporary incapacity benefit would exceed the member’s pre-disability income, this may impact on the deductibility of the insurance premiums and potentially the amount that can be paid.
Term life
In situations where term life insurance is held with superannuation, on the death of a member the benefit must be cashed as soon as practicable (SIS Regulations 6.21). Generally the amount must be paid to the member’s legal personal representative or to a dependant of the member in the form of a lump sum and/or where eligible an income stream. To be eligible to commence an income stream, section 6.21(2A) of the SIS Act requires the beneficiary to be a dependant of the member and where they are a child they must be:
- under 18
- under 25 and be financially dependent, or
- permanently (or likely to be permanently) disabled, suffering from an intellectual, psychiatric, sensory and/or physical impairment for which ongoing support is required and
- they have substantially reduced abilities for communication, learning and mobility.
From a tax perspective, the amount of tax payable depends on whether the person is defined to be a death benefits dependant under the Income Tax Assessment Act (ITAA) section 302-195. That is, a person who was the deceased’s spouse, former spouse, child under age 18, a person who was dependent on the deceased at the time of death, or a person who had an interdependent relationship with the deceased. It should be noted that this definition is extended to include anyone who receives a death benefit in cases where the deceased died in the line of duty and was a member of the defence force, Australian federal, state/territory police, or a protective service officer.
In cases where a death benefit is paid to a person who is a death benefit dependant, irrespective of their age, the lump-sum amount will be 100 per cent tax free.
Where the death benefit is paid to an eligible beneficiary as an income stream, any insurance proceeds will form part of the taxed element. The new income stream will consist of unrestricted non-preserved money and any pension payments will be tax free, if the deceased or the new pensioner is aged 60 or over (assuming there are no untaxed monies). Where an untaxed element exists, not really an issue for SMSFs, that portion is taxed at the pensioner’s marginal tax rate less a 10 per cent rebate.
In the situation where neither the deceased nor the new pensioner is aged 60 or over, only the tax-free portion will be tax free. The taxed taxable component will be taxed at the pensioner’s marginal tax rate less a 15 per cent rebate. For completeness, the untaxed element will be taxed at the pensioner’s marginal tax rate.
In cases where a death benefit is paid to a person who is not a death benefit dependant, they can only receive the payment as a lump sum. Where this occurs, it is important to consider whether the trustee has claimed a tax deduction for the insurance premium, or will be claiming one for the future liability to pay benefits, as this will cause the taxed component to be modified and the creation of an untaxed element (an issue for all super funds including SMSFs) where the deceased died under age 65 (ITAA section 307-290).
From a tax perspective, the tax-free portion will be tax free, the taxed element will be taxed at 15 per cent plus Medicare levy and the untaxed element at 30 per cent plus Medicare levy.
Total and permanent disablement
Where a member becomes entitled to a TPD benefit, the amount can generally be paid as a lump sum and/or an income stream.
If the member chooses to start an income stream, the insurance proceeds will generally form part of the taxed component of the benefit, which is used to establish a pension consisting of unrestricted non-preserved money.
From a tax perspective, where the member has reached the age of 60 (assuming no untaxed element) the entire amount will be tax free. In situations where an untaxed element exists, that portion will be taxed at the pensioner’s marginal tax rate less a 10 per cent rebate.
Where the person is under 60, then the tax-free portion of each pension payment will be tax free and the taxed taxable component will be taxed at the pensioner’s marginal tax rate less a 15 per cent rebate (the rebate is nil where it relates to an untaxed element).
If, however, the member takes the benefit as a lump sum, any insurance proceeds are generally added to the taxable portion. In addition, the tax-free component needs to be increased, based on the number of years to age 65, as a proportion of the member’s total service period (ITAA section 307-145). The lump sum is then taxed based on the member’s age.
That is, the recalculated tax-free portion will be tax free, and the taxable taxed element is taxed at:
- Under preservation age: 20 per cent plus Medicare levy.
- Attained preservation age but under age 60: 0 per cent up to the low-rate threshold and then taxed at 15 per cent plus Medicare levy.
- Age 60 and over: tax free.
For completeness, where a taxable untaxed element exists, then that portion is taxed at:
- Under preservation age: 30 per cent plus Medicare levy up to the untaxed plan cap. Any excess is taxed at the highest marginal tax rate.
- Attained preservation age but under age 60: 15 per cent up to the low-rate threshold, and then taxed at 30 per cent plus Medicare levy up to the untaxed plan cap. Any excess is then taxed at the highest marginal tax rate.
- Age 60 and over: Taxed at 15 per cent up to the untaxed plan cap, with any excess taxed at the highest marginal tax rate.
In summary
A trustee is now required to consider and regularly review a member’s insurance need as part of the fund’s investment strategy. From a broader planning perspective, taking into account a person’s insurance need is an important consideration, which from 1 July 2013 may be a key factor in determining whether any advice has satisfied the best interest obligations, especially in the case where a client requires regular contributions from employment-related activities to achieve their desired superannuation goals.
Importantly, the decision to hold insurance inside of super has a number of issues that need to be considered and hopefully it also provides an opportunity to enhance the advisory relationship that currently exists.