Temporary incapacity peace of mind

Dan Butler

SMSFs can provide much-needed monetary relief for individuals suffering temporary incapacity, writes Daniel Butler.

Most of us are aware superannuation benefits can be paid out on retirement, as well as on suffering permanent incapacity and on death. However, many are not aware our super savings can also provide some welcome relief on suffering temporary incapacity.

Those who suffer temporary incapacity can receive income support during their period of temporary incapacity. There are strict rules that govern this support that need to be carefully understood.

Moreover, not all super funds or SMSF deeds provide this support. Thus it’s worthwhile checking whether you’re covered just in case it’s ever needed.

What is temporary incapacity?

Temporary incapacity is defined in regulation 6.01(2) of the Superannuation Industry (Supervision) Regulations (SISR) to mean: “Temporary incapacity, in relation to a member who has ceased to be gainfully employed (including a member who has ceased temporarily to receive any gain or reward under a continuing arrangement for the member to be gainfully employed), means ill-health (whether physical or mental) that caused the member to cease to be gainfully employed but does not constitute permanent incapacity.”

We now contrast this definition with that of permanent incapacity as we will examine a number of interesting points that arise from the comparison.

Firstly, we note the definition of temporary incapacity is ceasing gainful employment due to illness that falls short of permanent incapacity. Secondly, there is no express criteria such as medical certification being required.

hirdly, the ATO has confirmed its view in Taxation Ruling 2012/6 at paragraphs 149, and 162 to 167 as:

“149. A disability superannuation benefit is defined in subsection 995-1(1) of the Income Tax Assessment Act 1997 (ITAA) to mean a superannuation benefit where:

a. the benefit is paid to a person because he or she suffers from ill-health (whether physical or mental); and

b.  two legally qualified medical practitioners have certified that, because of the ill-health, it is unlikely that the person can ever be gainfully employed in a capacity for which he or she is reasonably qualified because of education, experience or training.

162. The general rules on payment of a member’s benefits from a superannuation fund are set out in Division 6.2 of the SISR. Under Division 6.3 of the SISR, the payment of a member’s benefits may be compulsory or voluntary.

163. Consistent with the sole purpose test, a complying superannuation fund can only provide a member’s preserved benefits on or after the time when a member satisfies a condition of release (regulation 6.18 of the SISR). Schedule 1 to the SISR identifies the conditions of release for these purposes together with any restrictions that apply to the provision of benefits when certain release conditions have been met.

164. The provision of a disability superannuation benefit to a member is determined by reference to the entitlements of the member under the trust deed, and more particularly, the operation of the conditions of release in Schedule 1 to the SISR. Accordingly, the matter of when and to what extent a member receives a benefit referable to the pay out under an insurance policy is not determined solely by the occurrence of the insured event and the receipt of a pay out by the trustee of a fund under the insurance policy.

165. The permanent incapacity of a member is listed in item 103 of Schedule 1 to the SISR as one of the conditions of release under which a superannuation fund can provide a benefit to a member and is the relevant condition of release that would have to be satisfied, in conjunction with the requisite two medical certificates, in order for a superannuation fund to provide a ‘disability superannuation benefit’.

166. Sub-regulation 6.01(2) of the SISR defines permanent incapacity in relation to a member as: ill-health (whether physical or mental), where the trustee is reasonably satisfied that the member is unlikely, because of the ill-health, to engage in gainful employment for which the member is reasonably qualified by education, training or experience.

167. In our view the degree of ill-health that the trustee of a fund must be reasonably satisfied exists in order that a member meets the definition of permanent incapacity under sub-regulation 6.01(2) of the SISR is for all practical purposes identical to that which two medical practitioners must certify for the payment of a disability superannuation benefit.

While the trust deed may not require certification by two medical practitioners for the purpose of satisfying the permanent incapacity condition of release, it would be expected that the trustee would rely on the advice of at least two medical practitioners in order to be reasonably satisfied that this condition of release has been met.

For the purpose of obtaining a deduction within subsection 295-465(1), this would equate to the certification required for a ‘disability superannuation benefit’.”

Broadly, the ATO has blended the ITAA definition of disability superannuation benefit with the permanent incapacity definition of SISR by stating two medical certificates are required, despite the SISR definition not expressly covering this criteria.

What benefit can be paid on suffering temporary incapacity?

A member who suffers temporary incapacity can obtain a non-commutable income stream (NCIS). The NCIS:

  • must be paid for the purposes of continuing (in whole or part) the gain or reward the member was receiving before their temporary incapacity, and
  • the payment must not exceed the period of temporary incapacity.

Clearly, a member cannot be paid a lump sum or by way of an account-based pension or transition-to-retirement income stream (TRIS) if they suffer temporary incapacity.

Also, the NCIS must not exceed the member’s pre-incapacity income. One point to be aware of is income protection/continuation insurance is generally capped at 75 per cent of the insured person’s gross income.

Moreover, such insurance is usually reduced by any other income or compensation the insured receives from their illness.

Thus, you should carefully examine the detail of any income protection/continuation insurance outside of super to see if there is a potential for the insurance support to be reduced on account of say an NCIS being provided by the member’s SMSF of $1000 a week, which reduces the $750 insured benefit that would otherwise be payable if the NCIS was not provided.

Another example worth keeping an eye on is where employees on paid sick leave are not eligible to receive an NCIS during the same period they are on that paid leave unless the NCIS supplements their sick leave to the level of their pre-incapacity income.

Thus, where the member is self-employed and does not have any other entitlement or insurance to cover their temporary incapacity, then an NCIS can provide welcome relief.

In particular, if a member does have income protection/continuation insurance that provides up to 75 per cent income replacement, then the NCIS could provide the remaining 25 per cent of income that cannot be provided by the fund, such as an SMSF.

Also when the member returns back to gainful employment, the NCIS must generally cease. As discussed above, there are a number of strict criteria to consider when implementing this strategy.

One further point that many do not fully understand is what type of amounts in an SMSF can fund an NCIS. These amounts can only be funded from so much of a member’s minimum benefits in a superannuation fund that do not relate to:

  • member-financed benefits, and,
  • mandated employer-financed benefits.

It is important to note here regulation 5.08(3) of SISR is a modification to the usual minimum benefits test. Under regulation 5.04(2), a member’s minimum benefits in an accumulation fund are all of the member’s benefits in the fund.

Thus, regulation 5.08(3) makes an exception to allow an NCIS to be funded for a member when they suffer temporary incapacity.

This means an NCIS can typically only be paid from a superannuation fund in respect of a member from any one or more of the following:

  • employer contributions in excess of the superannuation guarantee (SG) level such as salary sacrifice contributions,
  • Member and SG contributions plus earnings thereon are minimum benefits that cannot be used towards funding an NCIS under regulation 5.08(3),
  • insurance proceeds received by the fund in respect of the member such as income protection/continuation insurance proceeds, and/or,
  • reserves maintained by the fund such as investment or general reserves.

Note that contribution reserves can only be applied towards members and must usually be allocated within 28 days of the end of the month in which the fund received the contribution.

Thus, to be able to implement this strategy, prior planning is required to establish the funding mechanism that can provide an appropriate NCIS cash flow. If, on the other hand, the member’s benefits only comprise SG and member contributions plus earnings thereon, an NCIS cannot be provided.

Given most adults do not have much insurance cover, this could result in member’s being left to their own devices when they suffer temporary incapacity and have no resort to their super savings nor insurance.

This can be very stressful and financially difficult for many self-employed people, particularly small business proprietors, farmers, artists, actors, tradespeople and contractors.

Is an NCIS for temporary incapacity taxable?

An NCIS will be taxable as ordinary assessable income and taxed at the member’s marginal rate plus applicable levies, as the income stream is not a pension or income stream, like an account-based pension or a TRIS that is eligible for a tax offset if your under 60.

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