This article considers how to claim tax deductions when insurance is held within superannuation.
From a super fund trustee perspective, one of the main benefits of offering life insurance within a super fund is the ability to claim tax deductions for any insurance premiums paid for death and disability cover.
However, another tax deduction may be available to the super fund if the trustee chooses not to claim a deduction for the premiums paid, but instead claim a deduction for the future liability to pay death or disability benefits. This can potentially allow the super fund to claim a much higher deduction overall.
Under section 295.460 of the Income Tax Assessment Act 1997 (ITAA 1997), a tax deduction may be claimed by a trustee of a fund for premiums paid, or a future liability, because of cover for:
death or terminal illness;
total and permanent disability (disability super benefit); or
Claiming tax deductions when insurance is held within super
Under section 295.465 of ITAA 1997, when insurance is held within super, premiums paid may be tax deductible to the super fund.
Term life insurance held within superannuation is generally 100 per cent tax deductible to the fund.
With total and permanent disablement (TPD) insurance cover, premiums are only deductible to the extent that the TPD insurance definition meets the ‘disability superannuation benefit’ definition in the Tax Act. The definition of a ‘disability superannuation benefit’ requires that the person is unlikely to ever be gainfully employed in a capacity for which they are reasonably qualified because of their education, training or experience.
If a super fund holds any occupation TPD insurance that is aligned to the definition of a disability superannuation benefit, then the premiums are 100 per cent deductible to the fund.
Own occupation TPD and trauma insurance (sometimes referred to as ‘living insurance’) could only be taken out within super before 1 July 2014. Where this type of insurance was taken out prior to 1 July 2014, the super fund can thereafter continue to hold the insurance within the fund, and also increase or decrease the sum insured, when required.
For pre-July 2014 standalone own occupation TPD policies inside super, premiums are 67 per cent deductible, as the policy may provide some benefits which do not meet the definition of a ‘disability superannuation benefit’. If own occupation TPD cover is linked to a Term life policy, premiums are 80 per cent tax deductible to the trustee. Trauma insurance premiums are not tax deductible.
When holding income protection insurance within superannuation, a full tax deduction can be claimed for the premium, provided the proceeds are intended to be paid in accordance with the temporary incapacity condition of release.
Future liability tax deductions
In the event of a client passing away or where they need to claim for a disability, the fund may be able to claim an alternative tax deduction for the future liability to pay a benefit.
In the case of a payment of a death benefit, terminal illness or TPD benefit (disability super benefit), the alternative election is only available where benefits are paid as a consequence of the termination of a client’s employment. This includes termination as an employee or a self-employed person.
In the case of temporary incapacity, the client must be unable to be engage in gainful employment due to sickness or injury.
To be eligible to claim the future liability tax deduction, the fund must have paid an insurance premium in that year, as demonstrated by private binding ruling 1012057834929; that is, the fund must have been in a position to claim a tax deduction for insurance premiums paid, to then be able to elect to use the future liability tax deduction.
This deduction is available to all super funds, but public offer funds don’t usually utilise the tax deduction for premiums paid. However, clients with their own self-managed super funds (SMSFs) could consider applying for the future liability deduction.
Calculating the future liability tax deduction
The amount of the future liability tax deduction is calculated as:
Benefit amount x Future Service Period / Total Service Period
The benefit amount is the amount of the lump sum paid, or the value of a pension payable. In the case of temporary incapacity, it is the total amount paid during the year of income.
Future service days are the number of days from the date of termination to the client’s last retirement day (usually age 65). In the case of temporary incapacity, it is the day the client ceased gainful employment and ends on the last retirement day (usually age 65).
Total service period is the number of days from the start of the eligible service period until the client’s last retirement date.
Election to claim the future liability deduction
To claim the future liability deduction, the trustee of the superannuation fund must make an election to not deduct amounts based on the premiums paid in the year in the event of a client passing away or where they need to claim for a disability, and instead, claim for the future liability to pay benefits.
The trustee can claim deductions based on the premiums paid up to the year the benefit is paid and, in the year that the insurable event occurs, elect to use the future liability tax deduction then.
The future liability election applies to all future years unless otherwise determined by the Commissioner of Taxation.
When should a fund consider claiming this deduction?
The future liability tax deduction does not increase the benefit paid by the super fund in the event of a client passing away or when a disability benefit is paid.
It provides a tax deduction to the fund which can be used to offset tax in the year the event occurs, or in future years. If tax losses are created by using the full tax deduction in one year, the remaining tax deduction can be carried forward to reduce assessable income in future years.
This provides an overall benefit to all remaining members of the SMSF, as the deduction may reduce current and future tax liabilities, and therefore effectively increase balances. If these members hold benefits in the accumulation phase, there is likely to be future income tax and capital gains tax (CGT) that can be offset by the remaining future liability tax deduction.
As the benefit may only be fully realised if the fund continues, it may not be beneficial for a fund to claim a future liability deduction if the fund is soon to be wound up. However, if a CGT event will be triggered upon assets being sold in the process of winding up the fund, then this deduction could potentially offset the CGT, if the full tax deduction is used.
The following case studies illustrate how the future liability tax deduction may apply in different scenarios.
following case studies illustrate how the future liability tax deduction may apply in different scenarios.
Case study 1: Member passes away
David and Julia, both aged 55, had an SMSF and were both employed. They each had $1.4 million of term life and TPD insurance cover. On 1 March 2018, David passed away. At the time of his death, he had been a member of the SMSF for 10 years.
The SMSF received a death benefit insurance payout of $1.4 million, which was added to his accumulation balance of $500,000. Julia decided to receive a death benefit pension of $1.6 million (being the transfer balance cap amount) and receive the remaining $300,000 of death benefit as a lump sum payment.
After David’s death, Julia’s adult son Michael joined the fund and in doing so, became a trustee of the fund.
The SMSF paid the life insurance premium of $2,000 on 1 February 2018.
Julia and Michael, as trustees, must now decide whether to claim the $2,000 premium paid as a tax deduction or claim a future liability deduction in 2017/18.
If the SMSF claims a deduction for the premium paid, it will receive a tax deduction of $2,000. If Julia and Michael choose not to claim a deduction for insurance premiums paid by the fund in 2017/18, the fund can instead elect to claim a tax deduction for the future liability to pay benefits. The deduction is calculated as follows:
Benefit amount x Future Service Period / Total Service Period
= $1.9 million x 10 years / 20 years
This deduction can be carried forward to future years, if not fully used in 2017/18.
In making their decision, Julia and Michael consider that Michael is only 30 and intends to be a member of the fund for at least the next 30 years. They also consider that Julia has used up her entire transfer balance cap and any accumulated money she holds in the fund will be in accumulation phase.
Having two members in accumulation phase means that if assets of the fund are sold, there might be CGT payable and the carried forward future liability deduction could offset CGT in the future. Also, if the fund has taxable income in future years, the deduction can also offset that income each year.
Case study 2: Member is totally and permanently disabled and receives a lump sum benefit
Kevin and Kim (age 50) are both members of their SMSF. They each hold standalone term life and any occupation TPD insurance, with a sum insured of $800,000 each, within the SMSF. They also have accumulated super balances of $500,000 each. The SMSF is made up of a property worth $900,000 and $100,000 in cash.
They have been members for five years when Kevin is involved in a car accident, resulting in cognitive issues, and becomes totally and permanently disabled. He ceases work in his own business and as a result, the insurance provider pays a TPD claim of $800,000 into the SMSF. The SMSF pays Kevin a total benefit of $1.3 million.
The premium on Kevin’s TPD insurance in the year he becomes disabled is $1,500 per annum. The fund could claim a tax deduction for the $1,500 premium or may instead elect to claim a deduction for the future liability to pay the disability benefit.
The future liability deduction would be equal to $975,000*.
After Kevin’s benefit is paid out, he ceases being a member of the SMSF. As Kim does not want to be a single member, she decides that she will wind up the SMSF and roll her super to a public offer fund.
They decide to sell the property, so that they can pay Kevin a cash lump sum benefit of $1.3 million and roll over Kim’s accumulated balance of $500,000 to the retail super fund. The accountant determines that the sale of the property will result in a capital gain of $500,000. If they elect to claim a future liability deduction, the fund could offset the entire CGT liability.
Case study 3: Member is temporarily incapacitated
Brad, Liz and Jonathon have all been members of their SMSF since 2013. They each hold term life, TPD and income protection insurance within the fund.
They are all employed when Brad becomes temporarily disabled, temporarily ceases working and claims his income protection benefit. He receives a benefit of $5,625 per month for six months.
In the year that Brad (age 35) was temporarily disabled, the income protection premium was $900 per annum. The SMSF could claim a tax deduction for the cost of the insurance or claim the future liability deduction, which would be equal to $28,928*. This has been calculated as:
$33,750 x 30 years / 35 years
In deciding whether to claim the deduction for the premium or the future liability, they need to consider that once they elect to claim a tax deduction for a future liability, they will no longer be able to claim a deduction for future insurance premiums.
* The figures in the case studies are approximate and have been calculated based on the number of years, instead of the number of days, for simplicity.
Where an SMSF meets the criteria to be able to claim a future liability tax deduction, it may be worthwhile for the trustee to consider whether it is best to claim the future liability tax deduction or claim the premiums as a deduction in that year.
As with any strategy involving tax law, SMSF trustees need to seek individual tax advice before using this strategy. However, when deciding which deduction to claim, super fund trustees could consider:
The age of the members – the younger the members are when they claim the insurance, the higher the future liability deduction will be (as they will have more future service days).
Whether or not the insured person is working when they become disabled or die (as they will need to terminate employment if in the event of a death, terminal illness or TPD payment).
Whether there will be any future members of the SMSF, and how long they will remain in the fund.
If the members are in accumulation phase or pension phase – if all the members will be in pension phase, future tax deductions will not be beneficial to the fund, as earnings on assets underlying the pension are received by the fund tax-free. However, with the introduction of the transfer balance cap, it is more likely that members will have some proportion of their super in the accumulation phase.
If an income protection benefit is paid, the future liability deduction may be less than claiming the insurance premiums in that year. Even if the future liability deduction is greater, it may not be worth missing out on claiming future premium deductions.