Holding insurance insurance inside superannuation is not right for everyone and when it goes wrong it goes very wrong
Holding insurance policies inside of superannuation can be a good option for many and comes with two compelling advantages:
However holding insurance inside superannuation is not suitable for everyone, and when it goes wrong, it can go very wrong so before looking at the list I need provide some important background (so important that it’s responsible for nearly all the list).
When insurance is held within super, the owner of the policy is the super fund NOT the individual.
On the surface this may not seem important; after all you are the beneficial owner of your super.
However this reality can cause problems, because when a successful claim is made against an insurance policy, the proceeds of the policy are paid into the super fund, not to the individual. The super fund must then release the funds to the member. However, superannuation has strict conditions of release; if one of these conditions is not met then the proceeds of the insurance claim may get stuck in super until a condition of release is met.
Onto the list of scenarios where you should reconsider holding your life insurance inside your super fund.
Total and Permanent Disability (TPD)
For a successful TPD claim, insurers must be convinced that due to illness or injury, claimants will never be able to work again. There are two broad categories of TPD insurance; “Any Occupation” and “Own Occupation”.
Each category has their own definition that must be met for a successful claim. Generally they require showing that in their Doctor’s opinion(s), the person making the claim will never again be able to work in:
Any Occupation: An occupation for which they are reasonably suited by training, education or experience.
Own occupation: Their usual occupation.
Permanent incapacity is a condition of release but legislation states that a member is taken to be suffering from permanent incapacity if:
The trustee of the fund is reasonably satisfied that the member's ill-health (whether physical or mental) makes it unlikely that the member will engage in gainful employment for which the member is reasonably qualified by education, training or experience. SISR 1.03C
This definition matches the “Any Occupation” definition very well and therefore if you are eligible for the insurance claim you will also meet a condition of release.
However if are paid under an “Own Occupation” definition, you may be successful in making a claim on your TPD policy, however your claim will be stuck in your super until you reach a different condition of release. Not much use in the short term.
Hold an Own Occupation TPD policy outside of your superannuation.
Super legislation allows for release of funds from superannuation under a condition known as “temporary incapacity”.
Temporary incapacity allows super funds to release income protection payments to members.
However the Temporary Incapacity is defined in the legislation as follows: “In relation to a member who has ceased to be gainfully employed (including a member who has ceased temporarily to receive any gain or reward under a continuing arrangement for the member to be gainfully employed) means ill-health (whether physical or mental) that caused the member to cease to be gainfully employed but does not constitute permanent incapacity. SISR 94 – REG 6.01
If you’re not currently gainfully employed, it’s not possible for ill-health to cause you to cease being gainfully employed (although it can cost you the ability to become gainfully employed in the future and therefore the ability to provide for yourself or your family.)
Hold an Agreed Value Income Protection policy outside of superannuation, and carefully check the policy terms regarding gainful employment.
Income Protection premiums are generally tax deductible regardless if they are held inside or outside of super.
Superannuation has a flat tax rate of 15%, when you make a concessional (before tax) contribution to super such as Superannuation Guarantee or salary sacrifice you pay 15% contribution tax (as long as it’s under the contribution cap).
When an income protection policy is held within super, your super fund will claim a return of 15% of the premium it pays for the income protection policy, this results in a net tax of 0% payable in your income protection premiums.
However, if you earn over $250,000 you are required to pay 30% contributions tax (Tax Division 293).
This means that you pay 30% tax on your funds going into super, however your super fund can still only claim a 15% (your superfund's tax rate) refund on your premiums, this results in an effective tax rate of 15%, this more than if you held your Income Protection policy outside of super.
Solution: Hold your Income Protection policy outside of Superannuation.
Many income protection policies offer extra features that can be used upon a successful insurance claim; these benefits can include rehabilitation payments, nursing care, advance payments and critical illness benefits (similar to trauma insurance).
When a super fund release funds under temporary incapacity, they have restrictions on what and how they can release to the member; these restrictions are known as cashing restrictions, they state that a payment made under temporary incapacity must be made as
A non-commutable income stream cashed from the regulated superannuation fund for:
(a) the purpose of continuing (in whole or part) the gain or reward which the member was receiving before the temporary incapacity; and
(b) a period not exceeding the period of incapacity from employment of the kind engaged in immediately before the temporary incapacity. SISR – Schedule 1
This means that the policy can’t provide these extra benefits.
Hold an Income Protection policy with your desired features outside of super OR hold a linked Income Protection policy (these will only be available in SMSFs or specific super funds)
Life Insurance & TPD Insurance.
Proceeds from Life Insurance and TPD insurance held policies held outside of super are generally not taxable.
Proceeds from Life or TPD insurance held in super may be taxable.
Life Insurance: Life Insurance paid to a non-tax dependent will incur up to 15% plus medicare.
TPD: Insurance depending on the members age the taxable portion of their superfund.
Determine whether your intended beneficiary is a tax dependent or not. If they are not tax dependents you should consider increasing the amount of insurance you have to cover the likely 30% (plus medicare) your dependent is likely to pay.
For TPD, it is difficult to determine the amount of tax you may be required to pay because the formula for doing so, requires the date of which you became Totally and Permanently Disabled, as this is obviously not known ahead of time. You may want to consider grossing up your TPD payment by 20% (+ Medicare) which is the amount of tax you are required to pay when withdrawing money out of Superannuation before your preservation age.
The cost of this larger sum insured must be compared to the cost of holding life & TPD insurance outside of superannuation.
Life, TPD & Income protection
Some super funds provide unitized insurance, unitized insurance is when the sum insured by an insurance is provided in units rather than specific amounts.
These unitized policies often compensate for the increased risk the insurance company undertakes (due to the person insured growing older and generally less robust) by decreasing the sum insured over time. Most other insurance policies will compensate for this risk by increasing the premiums, although it is possible to obtain policies where the premiums do not go up with age.
The amount of sum insured under an insurance policy is very easy to reduce however they can be very difficult to increase, if you find you need a higher level of insurance (for example you undertake a higher level of debt) and your health has deteriorated you may be subject to extra loading or exclusions or you may be unable to get insurance at all.
It is advisable to manually reduce insurance to reflect your changing needs rather than find yourself needing to reapply for insurance you once had.
Apply for a policy that has a fixed sum insured, if you are worried about premium increases, you can manually adjust your sum insured or apply for a policy with a “Level Premium” it should be noted Level Premium policies will be initially more expensive.
Note: From the 1st of July 2014, insurance policies held within super must match with the conditions of release under SIS legislation, however policies taken out before this date will be "grandfathered" .