Income protection insurance - choosing a lump sum or monthly benefit

When it comes to income protection, receiving the payment as a lump sum or as a monthly benefit can make a big difference to clients, writes Jeff Scott.

Income protection is a great way to ensure a continued income stream in the event of being ill or injured and unable to work, but clients who elect for a monthly benefit rather than a lump sum payment could find themselves exposed at claim time.

With one in three Australians off work due to illness or injury for a continuous period of at least three months during their working life, and with statistics showing that most families would experience significant financial difficulties with no income for this period, the need for income protection is compelling.

There is an important choice clients must make when deciding to receive a monthly or lump sum payment. A monthly payment will generally cover 75 per cent of pre-disability salary.

But what happens if you can never return to your chosen occupation and have major upfront and ongoing costs such as treatment, personal care and home modifications?

For an individual involved in an accident who becomes a quadriplegic, depending on the circumstances, these costs could include $15,000 for a special exercise bike, $28,000 per year for care-givers, $5,000 for a special hospital style bed, plus more than $30,000 a year for a range of complementary therapies such as kinesiology, reflexology and cranio-sacral massage.

Imagine this: a 35-year-old client, earning $150,000 per annum, with a monthly benefit of $9,375 per month, has a surfing accident where he hits a sandbar and breaks his neck, leaving him a quadriplegic.

In most circumstances, the client would continue receiving the regular monthly income payment through to the policy termination age (normally age 65).

The client would continue to submit regular medical and claim forms, usually on a monthly or quarterly basis.

The benefits would be taxed at the client’s normal marginal tax rate.

The gross annual benefit payment would be $112,500 ($9,375 x 12), while the net benefit after tax is $80,612.50 per annum.

Alternatively, the life insurance company may offer a lump sum ‘commuted value’ payment in lieu of making payments through to age 65.

This is normally an ex gratia offer at the discretion of the life insurance company. In this case, the entire lump sum benefit will be taxed as income in the year of receipt at the individual’s marginal tax rate (up to 46.5 per cent).

Based on actuarial calculations, let’s assume the client receives 15 times the annual benefit of $112,500. The gross annual benefit payment would be $1,687,500, but the net amount after tax would only be $927,962.50.

Clients may elect for a lump sum payment on total and permanent disablement (TPD) instead of a monthly income protection benefit.

This special TPD rider benefit within an income protection policy is only provided by two insurance companies in Australia.

CommInsure was granted a special taxation ruling by the Australian Taxation Office (ATO) that allows a client who is totally and permanently disabled (own occupation) and receiving income protection payments a choice in this situation: continue to receive a taxable monthly benefit, or receive a tax-free lump sum benefit.

However, there is one condition required by the ATO. The premium cost of the income protection policy will not be totally tax deductible, as in the first two options, but only 90 per cent tax deductible.

This means if a client was paying a premium of $1,000 per annum, only $900 would be tax deductible if they chose this option at the time of policy application.

Because the client is under 40 in this scenario, the lump sum benefit is 15 times the annual benefit of $112,500.

The gross annual benefit amount and net benefit would be $1,687,500 (no tax). The lump sum, if invested, would need to earn between 2.78 per cent and 6.6 per cent to generate the same income stream through to age 65 as in the first option.

By electing the tax-free lump sum, the client was able to afford choice. He spent the payment on medical expenses, carers, rehabilitation, equipment and paying off debt, while investing any excess proceeds. The lump sum also allowed his wife to leave her job to care for him.

Jeff Scott is the executive manager of business growth services at CommInsure.