Why income protection insurance matters for high income earners

Jon de Fries explains why income protection insurance can be just as important for higher income earners and discusses some policy ownership issues.

Many high income earners, especially younger workers, rely significantly on the income they receive from employment or self-employment to meet their living expenses, service high debt levels and/or fund future wealth creation strategies.

As a result, an illness or injury that leaves them unable to work could have a detrimental impact on their lifestyle if suitable protection strategies haven’t been implemented.

Even if they’re in a strong net asset position, self-insuring may not be a smart strategy for a number of reasons. For example:

• the assets may be illiquid;
• they could be forced to sell during adverse market conditions;
• significant exit costs (such as capital gains tax) could be payable; and
• longer term wealth creation plans could be undermined.

In other words, with the exception of clients who have significant net wealth and/or derive a large proportion of their income from passive sources such as investments, income protection (IP) insurance can be just as important for high income earners as it is for everyday Australians.

Some life insurance companies have also increased the maximum IP claim benefit certain people can receive to significantly above industry standards. So high income earners now have the flexibility to take out greater protection where needed.

Finally, where some degree of self-insurance may be a viable option, clients may still want to use IP insurance and reduce the premium cost by selecting a longer waiting period or shorter benefit payment period.

Superannuation versus self-ownership

IP insurance can either be self-owned, or owned by the trustees of a super fund.

For higher income clients who are eligible to claim their super contributions as a tax deduction or are able to make salary sacrifice contributions, the after-tax cost will generally be the same as self-ownership where they can claim the IP premiums as a tax deduction.

Also, in both cases, the benefits are assessable to the life insured.

However, you should keep in mind these super contributions will count towards the concessional contribution (CC) cap*, regardless of whether they’re used to purchase investments or insurance.

As a result, higher income clients with sufficient surplus cash flow may be better off using up the CC cap for investment purposes and/or funding Life and TPD insurance premiums.

This is because there are tax incentives for using CCs for these purposes that are generally not available outside super.

But regardless of the CC cap implications, taking out IP insurance in super can offer some other benefits — particularly when purchased by the trustees of a self-managed super fund.

For example, with clients aged 55 or over, the claim proceeds could be used to pay a transition to retirement pension where a 15 per cent tax offset is available to age 59 and no tax is payable at age 60 or over.

Furthermore, regardless of the client’s age, the claim proceeds could be retained in the concessionally taxed super environment with a greater degree of asset protection.

Company and discretionary trust ownership

Another option is for the IP policy to be owned by a company or the trustees of a discretionary family trust used to carry on a business, where the business pays the premiums to provide a salary continuance benefit for its employees.

In this scenario, generally, the premiums are deductible to the business and the benefits are ultimately assessable to the employee.

Employees will include principals and other people who receive a salary, wage, employer super contribution or reportable fringe benefit from the business. This does not include people who are purely reimbursed by company dividends or trust distributions.

Alternatively, an employee (as described above) can own an IP policy and the business can pay the premiums as a fringe benefit for the employee.

In this situation, the business can claim the premiums as a tax deduction, the benefits will be assessable to the employee and, because the premiums are ‘otherwise deductible’ to the employee, the business is not liable for fringe benefits tax.

However, if the company or discretionary trust owns the IP policy and another party (such as a company shareholder or trust beneficiary) pays the premiums, the premiums would generally not be personally deductible to the other party.

This is because, in accordance with section 8-1(1)(a) of ITAA 1997, the other party can only claim a deduction for an expense they incur ‘to the extent that it is incurred in gaining or producing [their] assessable income’.

This is a complex area and, in the absence of any public ruling or interpretive decisions, clients should seek advice from a taxation professional before making any decisions regarding the ownership of insurance policies.

* The CC cap is $25,000 per annum or, if your client is aged 50 or over, $50,000 per annum until 30 June 2012 and $25,000 pa thereafter.

However, the Government recently proposed in response to the Henry Review of taxation that the CC cap will remain at $50,000 pa from 1 July 2012 for people aged 50 or over with super balances below $500,000.

Jon de Fries is the national manager of insurance strategy at MLC.