Income protection: inside or outside super?

Since March 28, 2007, trustees of superannuation funds have been able to claim tax deductions for income protection cover with benefit periods of longer than two years (TD 2007/3).

The most significant question is then, is it better to have income protection insurance inside or outside superannuation?

Core benefits

A member may have an agreed value policy that pays 75 per cent of their income at application, however, the client needs to be careful if their income falls by more than 25 per cent. Any excess benefits that would provide the client with more than 100 per cent of their pre-disability income would be retained in the superannuation fund.

A member would not be eligible for temporary incapacity benefits if they are receiving sick leave benefits, as this normally replaces 100 per cent of their pre-disability income.

In addition, if the client is unemployed, on sabbatical, on maternity leave, or a homemaker and not earning an income, then they may not be entitled to any benefits from the superannuation fund, even if they have an agreed value policy.

So, the insurance company is still liable to pay the benefit to the superannuation fund, but the superannuation fund is not permitted to pay the benefit to the member.

Ancillary benefits

Various ancillary benefits offered under ordinary income protection policies are not available in the superannuation environment, or have significant limitations.

Should your client become a victim of the credit squeeze and find themselves involuntarily unemployed, some income protection policies now cover bank loans (home loans, investment loans and margin loans) minimum monthly repayments while they are unemployed (this may be for three months to 12 months). However, these benefits are not available via superannuation.

Certain critical illness benefits and rehabilitation benefits are often only available via ordinary policies. If these benefits are available via a superannuation fund, clients must closely examine the conditions under which these benefits can be released from superannuation.

Inside superannuation, benefits can only be paid for the period of incapacity. If the client is disabled for two months, but because of receiving a ‘specific injuries benefit’ or a ‘crisis benefit’, the superannuation fund receives a benefit that pays 18 months, then the difference in the benefit (15 months) is retained within the fund.

Underwriting

Individual policies normally require some underwriting. Individuals will also be required to supply proof to the insurance company that they have earned the salary they want to insure.

The main advantage of insurance via a superannuation fund is that it may provide some level of protection to those who may not be able to arrange, or afford, retail life cover.

People with an existing condition or in a high-risk occupation can generally obtain some degree of cover via their super fund at a reasonable cost, as they are accepted as part of a wider group of people. The disadvantage for someone who leaves the fund without a continuation right, is that it may be expensive or difficult to obtain retail cover.

Cost of premiums

Let’s look at the cost of premiums. Outside superannuation, the premiums are normally fully tax deductible if the life insured and the policy owner are the same person (s8-1 ITAA 1997). Also, under the ‘otherwise deductible’ rule, an employer may pay income protection premiums on behalf of their employees without incurring a Fringe Benefits Tax liability (s52 FBTAA 1986).

It should be noted that every dollar spent on insurance premiums is one less dollar that can be invested for retirement.

Secondly, depending upon the employment contract an employee has with his/her employer, if an employee chooses to salary sacrifice his income protection premiums it may reduce or even eliminate the employer’s Superannuation Guarantee (SG) liability.

Finally, the concessional contribution limits must always be considered. In 2008-09, these limits were $50,000 for individuals aged under 50, and $100,000 for those aged 50 and over. The recent Federal Budget has proposed that these limits reduce for the 2009-2010 financial year to $25,000 and $50,000, respectively.

This means that concessional contributions to all superannuation funds (which includes salary sacrifice and SG contributions) cannot breach these limits.

Taxation of benefits

It’s worth considering the taxation of benefits. The simple point is that whether the benefit is paid from super or is paid from an ordinary policy, it is normally taxed the same — that is, as ordinary income at the individual’s marginal tax rate. There are some notable exceptions, though, where a policy outside superannuation is more beneficial.

Under an income protection policy, if an ancillary benefit for critical illness is paid as a lump sum benefit (not a monthly benefit), then it may be tax free (ATO ID 2004/942). However, this tax advantage may not be available under superannuation.

Inside superannuation, if a member of the fund is unable to work because of injury or illness, then the taxation of the benefits will be identical to outside superannuation except in one notable situation. If a person is totally and permanently disabled, based upon the ‘any occupation’ definition, the payment will attract a 15 per cent tax offset.

It should be noted that the typical income protection policy uses an ‘own occupation’ definition, which states that if due to injury or illness you are unable to perform your own occupation, and you satisfy the waiting period, then you will be entitled to the appropriate benefit — this is the same inside or outside superannuation.

To be entitled to the 15 per cent offset mentioned above through superannuation, the member of the superannuation fund must be totally and permanently disabled to such an extent that they are unlikely to ever perform any occupation again based upon the member’s training, education and experience.

While having income protection insurance inside of superannuation may be an effective strategy in terms of gaining access to available cash flow to pay premiums, members of superannuation funds must be aware of the potential limitations that exist when meeting conditions of release from the fund.

Jeffrey Scott is executive manager, Business Growth Services, CommInsure.