Fnding TPD insurance via super

Andrew Lowe

In addition to life insurance (death cover), it is generally possible to fund total and permanent disablement (TPD) insurance via superannuation.

While the upfront tax consequences of funding TPD insurance do not differ from death cover, payment of the proceeds of a TPD policy to a superannuation fund member brings with it some additional considerations.

Payment of a TPD benefit

In order to receive a benefit from a superannuation fund a member must generally have satisfied a condition of release, including retirement for someone who has reached their preservation age, or attaining age 65.

A person may also satisfy a condition of release where they have ceased gainful employment and are permanently incapacitated.

A person is permanently incapacitated where a superannuation fund trustee is reasonably satisfied that the member is unlikely, because of physical or mental ill-health, to ever again engage in gainful employment for which the member is reasonably qualified by education, training or experience.

Where a TPD policy owned by a superannuation fund pays benefits upon TPD, where TPD is defined similarly to permanent incapacity, it would generally be possible for the proceeds of the policy to be received by the superannuation fund trustee and then paid to the member under the permanent incapacity provisions.

However, it may be possible that the definition of TPD used in the life insurance policy differs from the requirements necessary to satisfy the permanent incapacity condition of release.

Such a situation may arise, for example, where a superannuation fund owns an ‘own-occupation’ or ‘homemaker’ definition TPD policy.

If an own-occupation TPD policy were to pay benefits to the policy owner where, for example, the life insured was unable to ever again be engaged in their own occupation, it is possible that person may not necessarily satisfy the permanent incapacity condition of release (that is, they are ‘own-occupation’ TPD but not ‘any-occupation’ TPD).

While this would see the life insurance proceeds payable to the superannuation fund, the proceeds could not be paid to the member until they satisfy a condition of release, such as attaining preservation age and being retired.

Taxation consequences of receiving a TPD benefit from a superannuation fund

It is, perhaps, a common misconception that TPD benefits paid from a superannuation fund as a lump sum are tax-free.

While part of a TPD benefit paid from a superannuation fund may be tax-free, part of the benefit will generally be a normal eligible termination payment (ETP) and taxed accordingly.

The portion of any benefit paid from a superannuation fund under the permanent incapacity provisions that will be tax free is the amount of the payment that represents a post June 1994 Invalidity Component.

The Government has proposed that the Invalidity Component be replaced by an Exempt Component from July 1, 2007.

An Invalidity Component is generally created where a person terminates employment because of disability and where two legally qualified medical practitioners have certified that the disability is likely to result in the person being unable ever to be employed in a capacity for which that person is reasonably qualified because of education, training or experience.

As we can see from the case study opposite, as a person approaches age, less of any TPD benefit represents an Invalidity Component and more of the benefit is a normal ETP.

The amount of the benefit that represents a normal ETP will be split into its normal ETP components.

Any portion of the benefit that represents a post June 1983 component will be taxed at a maximum 21.5 per cent (where under age 55 and within Reasonable Benefit Limits).

From age 55, the post June 1983 low rate tax amount ($135,590 for 2006-07) will be available (subject to other benefits received on or after age 55) with the remainder being taxed at up to 16.5 per cent.

The Government has proposed that superannuation benefits received on or after age 60 will be tax free (in most cases) from July 1, 2007, this would include TPD payments.

Taxation planning points

In order for a post June 1994 Invalidity Component to be created, a person must terminate employment because of disability.

The Australian Taxation Office is of the view that a sole trader or partner in a partnership is not in an employment arrangement, therefore cannot terminate employment and will not be eligible for the creation of an Invalidity Component.

Persons who are employed by their own trust or company will be able to terminate employment.

The Government has proposed that from July 1, 2007, sole traders and partners in partnership will be able to qualify for the new Exempt Component.

Satisfaction of the incapacity condition of release allows a person to access their superannuation benefits but is not a compulsory cashing condition.

It may be more beneficial from a taxation planning perspective to rollover the payment to another superannuation fund rather than receiving it as a lump sum payment.

Rolling over will defer the payment of tax and will allow a client to selectively draw down their benefit from, say, just the Invalidity Component, leaving the balance of the benefit untouched until after age 55 or 60.

RBL consequences receiving a TPD benefit from a superannuation fund

An Invalidity Component is not assessed against the recipient’s reasonable benefit limit (RBL) when received as either a lump sum or in the form of an income stream.

Any pre or post 1983 benefits will be assessed against the recipient’s RBL. It is important to remember that where benefits are received before age 55 and assessed against the lump sum RBL, that RBL is discounted by 2.5 per cent for each year that the recipient is less than age 55.

The Government has proposed that RBLs be abolished from July 1, 2007.

Inside or outside of superannuation?

It has been suggested that because of the issues discussed above, all TPD insurance should be funded outside of superannuation. Such conclusions may be premature.

Access to TPD benefits is a very important consideration, and the risk of being unable to access ‘own-occupation’ TPD proceeds (if such a policy is used) must be considered.

The taxation consequences of the payment should also be considered. Broadly, however, even if a client were to pay 21.5 per cent tax on the entire sum insured (that is all post June 1983, no Invalidity Component, before age 55, but with no excessive amount) it is important to remember that the premium could be funded from pre-tax dollars via deductible superannuation contributions (including salary sacrifice contributions).

Effectively, this allows a person, subject to underwriting limits, to increase the sum insured for any likely income tax liability and still pay less in after tax terms for the benefit.

Funding TPD insurance via superannuation can be tax advantageous.

However, access to the benefit and the taxation and RBL consequences of a payment of the benefit, and the impact of the Government’s proposed superannuation reforms, must be considered in any decision to fund such cover via superannuation.

Andrew Lowe is head of technical services at ING .