Toolbox: Tax-effective personal life insurance funding

Premiums for life insurance, where the life insurance is used for personal purposes are, with the exception of income protection, non-deductible and are effectively funded from after-tax earnings. However, by structuring the ownership of personal policies via superannuation, it may be possible to fund such premiums from pre-tax earnings.

Deductible superannuation contributions, made by either an employer in respect of an eligible employee (including superannuation guarantee and salary sacrifice superannuation contributions) or an eligible person (including the self-employed and substantially self-employed), can be used to fund life insurance premiums.

Structuring life insurance via superannuation allows us to significantly increase sums insured for no additional net cost to clients, or to provide clients with a significant reduction in net premiums while maintaining the same sum insured.

Example:

Mark, age 40, is a self-employed accountant with earnings after significant business expenses of $100,000 per annum.

Mark is looking to provide financial security for his family in the event of his death or total and permanent disablement (TPD).

Mark believes he requires the following cover:

Death cover — $1,200,000; and

TPD cover — $600,000.

Conveniently, but perhaps inappropriately, these amounts are approximately equal to Mark’s flat dollar pension and lump sum reasonable benefit limits (RBL) respectively.

A term life insurance policy providing the above required cover, owned by Mark, would cost Mark approximately $1,386 in the first year.

In order to fund the first year’s premium, Mark will need to earn $2,692 of pre-tax income (Mark is paying tax at the 48.5 per cent marginal rate).

However, as Mark is an eligible person (he is self-employed), he is entitled to a tax deduction for the first $5,000 of superannuation contributions, plus 75 per cent of any additional contributions, subject to age-based deduction limits.

So, if Mark was to make a deductible superannuation contribution with this $2,692 (instead of receiving it as income when it would be taxable at a rate of 48.5 per cent), the full amount would be available to fund life insurance premiums.

This increased amount would allow Mark to fund the following cover:

Death cover —$2,379,356; and

TPD cover — $1,189,678.

The net cost to Mark for each of these amounts of cover is exactly the same ($1,386).

Alternatively, Mark could maintain his original sums insured but reduce the net cost of premiums, by using pre-tax earnings to fund the premium of $1,386, to just $714 in the first year.

Taxation of life insurance benefits funded via a superannuation fund

Life insurance proceeds paid via a superannuation fund are taxed depending on the nature of the payment, whether lump sum or pension (to be discussed below), the type of payment and the recipient (for death benefits only).

Death benefits paid as a lump sum

Death benefits paid as a lump sum to dependants of the deceased fund member are tax-free up to the deceased’s pension RBL. Any excessive amounts paid as a lump sum are taxed at the highest marginal tax rate.

Death benefits paid as a lump sum within the pension RBL to non-dependants are taxed as ordinary ETPs (but may include an untaxed post-June 1983 component). Any excessive amounts paid as a lump sum are taxed at the highest marginal tax rate.

Death benefits paid to estates are taxed depending on whether the ultimate beneficiary of the estate is a dependant or non-dependant.

Death benefits paid as an income stream

Life insurance proceeds paid via a superannuation fund are generally paid as a lump sum. However, there may be circumstances where the payment of proceeds as an income stream may be more advantageous for beneficiaries. In such circumstances, and where requested by either the member or beneficiaries, many superannuation funds can pay benefits as an income stream to dependants.

Benefits paid from a superannuation fund as an income stream will generally be assessed against the RBL of the recipient (other than a pension paid to a dependant child of less than age 18 which is not assessed for RBL purposes).

To the extent that an income stream commences within RBLs, any taxable income payments will attract a 15 per cent tax rebate, irrespective of the age of the recipient.

TPD benefits

TPD benefits paid as a lump sum may be treated as ordinary ETPs of the recipient. The ETP may contain a post-June 1994 invalidity component, which is paid tax-free to the member.

Contributions tax and superannuation surcharge

Employer superannuation contributions, or personal superannuation contributions for which a tax deduction is claimed, will generally be subject to a tax of 15 per cent (commonly known as ‘contributions tax’) upon entry to a fund.

However, superannuation funds are generally entitled to a tax deduction in respect of life insurance premiums and this will reduce the taxable income of the fund such that contributions tax is not payable.

Employer superannuation contributions, or personal superannuation contributions for which a tax deduction is claimed, made in respect of higher income earners (those with ‘adjusted taxable income’ of over $94,691 for 2003-04), are generally subject to an additional superannuation surcharge of up to 15 per cent.

Andrew Low is technical manager,ING .