Toolbox: Super, insurance & RBLs: how far do you go?

Some clients need such substantial insurance cover that to provide it through super may ultimately give rise to excess benefits. But should that necessarily deter them from insuring that way? In many cases, super can be a more effective way to arrange insurance cover and recent legislative changes that have seen a reduction in the maximum surcharge rate and the overall tax on excess benefits mean it is certainly an option worth discussing with your clients.

Cost is a major consideration, so we’ve analysed the issue by comparing the pre-tax cost of financing death cover through super, outside super or a combination of both.

Cost and convenience are the main arguments for insuring through super. Funding the premiums indirectly from Jane’s pre-tax earnings via salary sacrifice significantly reduces the cost. And there are cash flow benefits of having the fund trustee pay the premiums directly to the insurer after deducting the cost from her account balance.

However, if a lump sum death benefit of $1,376,106 were to be paid it would be assessed against her pension RBL (currently $1,176,106) resulting in an excess benefit.

Let’s look at the cost if Jane were to arrange the cover outside super.

Another option is to take $1 million cover inside super (to ensure Jane remains within her pension RBL), and purchase a non-super policy for the balance.

This way the bulk of the premiums will be funded cost-effectively from pre-tax salary sacrifice contributions. However, those contributions will be subject to both fund income tax of 15 per cent and the maximum super surcharge (14.5 per cent for 2003-04). If Jane receives a tax credit for the fund’s deductible expense of providing the cover, this will largely offset the effect of the income tax.

What about tax on the benefits?

Where a lump sum death benefit is paid to a dependent of a member who was in accumulation phase at the time of death, the benefit will be tax-free unless it exceeds the deceased person’s pension RBL. However, if the benefit is paid to a non-tax dependant, for example, an adult son or daughter, and includes a post ’83 component, part of that component will be treated as an untaxed element and be subject to tax at the rate of 30 per cent (excluding Medicare). The untaxed element arises where the insurance premiums for the death cover, or part of the death benefit itself, is an allowable deductible expense to the fund.

The RBL treatment is slightly different when the death benefit includes an insured component. Regardless of who the benefit is paid to, the post ’83 component will generally include an untaxed element. As only 85 per cent of that untaxed element counts towards your client’s RBLs, this can produce a more favourable RBL result than if the post ’83 component was all taxed element.

This taxed versus untaxed element is a critical aspect of RBL planning when determining how much cover to provide through super. And a key factor is the client’s ‘future service period’ — that is, the period from their date of death to their last retirement date (typically, age 65).

The taxed element of the post ’83 component is calculated as:

[ETP (less any excessive component) x eligible service period]÷(eligible service period + future service period)

and the untaxed element is the remainder.

Based on this formula we can calculate the level of cover that, when added to Jane’s existing super benefits (all post ’83), will not exceed her pension RBL.

Using the same methodology, let’s now look at the results if we take all the insurance cover inside super — even though this would create an excess benefit.

Interestingly, even with an excess benefit, in pre-tax terms, this option is $836.53 cheaper than taking all the cover outside super — a significant saving. It is marginally ($10) more expensive than the combination of super and non-super policies, but that is probably outweighed by the simplicity plus the availability of tax effective estate planning options that may be offered through Jane’s superannuation fund. This gap will close further as the maximum surcharge rate reduces. At a maximum surcharge rate of 12.5 per cent the difference is less than $4.00.

As always, it is important to assess each case independently. The best solution may depend on your client’s age, length of service and the type and level of cover they require. It may also depend on their employment status partly because premiums that are funded from personal or spouse contributions do not have the same tax treatment as the salary sacrifice example we have used.

David Shirlow is head of technical services, Macquarie Financial Services.