When helping your clients to adequately prepare for their future, total and permanent disability (TPD) insurance adds a layer of financial protection should your client suffer a permanent injury or illness, making it impossible to return to work.

Holding TPD insurance inside super is a common strategy to manage the affordability of the insurance premiums. Many financial planners are aware of the increased complexity this presents,  including the common need to increase insurance cover, the options to fund the premiums, and explaining the impact on a client’s retirement savings.

Also, what happens after the insurance proceeds are paid into the member’s super account? And, how do you, as a financial planner, help your clients manage these funds?

Commonly, the member (your client) will require a substantial portion of this as a lump sum to fund large, one-off expenses, like debt clearance, home and car modifications, and mobility aids. Plus, they will need an ongoing income stream for day-to-day living expenses.

A common misconception is that lump sum capital requirements should be taken as a lump sum super withdrawal. We’ll explore why this may not be the case.

Case study 1: Selena

Selena, who is 38 years old, took a life and TPD insurance policy within her taxed super fund four years ago. She has just received a TPD claim, and insurance proceeds of $1.5 million was paid into her super fund.

The TPD insurance proceeds are not taxable to the super fund and form part of the taxable (taxed) component, bringing her super fund balance up to $1.75 million, all taxable (taxed).

The start date of her super fund is 20 May 2004, she stopped being capable of being gainfully employed on 12 March 2021, and her 65th birthday will be on 8 August, 2048.

Note: Different rules apply to clients of at least preservation age, outlined in the table in the Appendix.

Access to insurance proceeds

As Selena’s policy was acquired by her super fund on or after 1 July 2014, the policy terms and conditions must be aligned with the super conditions of release. Her member benefits (including the insurance proceeds) should appear as unrestricted non-preserved, indicating that they can be accessed (as a lump sum and/or income stream) by Selena at any time.

If Selena’s policy was acquired by her super fund before 1 July 2014, the policy terms and conditions may not align with the super conditions of release. The insurance proceeds are only accessible if Selena can satisfy a condition of release, which is generally permanent incapacity for someone less than preservation age (age 60 for Selena).

A super fund trustee is usually satisfied that a member is permanently incapacitated where two doctors have attested that the member is unlikely, because of ill-health (physical or mental) to engage in gainful employment for which they are reasonably qualified by education, training or experience.

If the member benefits (including the insurance proceeds) do not appear as unrestricted non-preserved benefits in their super account, the member or their planner should contact the super fund to determine whether the original evidence provided for the insurance claim is sufficient to satisfy the permanent incapacity condition of release. If not, the member or their planner will have to complete the appropriate permanent incapacity form for the super fund to be able to make the super benefits (including the insurance proceeds) accessible.

Withdrawing lump sums

If Selena withdraws a lump sum, the tax-free component is tax-free. The taxable (taxed) component is added on top of her assessable income and where it falls across the 32.5 per cent, 37 per cent or 45 per cent marginal tax rate, a tax offset applies (12.5 per cent, 17 per cent and 25 per cent respectively) to reduce tax payable to a maximum of 20 per cent (plus Medicare levy).

Note: A common misconception is that any lump sum requirements should be accessed as a lump sum. This could lead to an adverse tax outcome.

This means:

• Selena could pay less than 20 per cent tax (plus Medicare levy) if it falls across the 0 per cent or 19 per cent marginal tax rate.
• by including the taxable (taxed) component in Selena’s assessable income, it may impact her eligibility to any other assessable or taxable income related measures (e.g. family tax benefits, HELP debt repayments, Government co-contribution, partner’s eligibility for the spouse contribution tax offset, and Division 293 tax (an additional tax on concessional contributions for higher income earners).
• it may be more beneficial for Selena to commence a disability pension attracting a 15 per cent tax offset (explored further below).

If Selena withdraws a lump sum, it will qualify as a disability lump sum, resulting in an increased tax-free component, calculated by:

Amount of benefit       x	days to retirement
	(days from start date to last retirement date)

This is calculated by:

Days to retirement = 10,012 days. This is the number of days from the day on which Selena stopped being capable of being gainfully employed (12 March, 2021) to her 65th birthday (8 August, 2048 – her last retirement date). If Selena’s employment would have terminated when she reached a particular age or completed a particular period of service, we would instead use the date she would reach that age or complete the period of service.

Days from start date to last retirement date = days from 20 May, 2004 to 8 August, 2048 = 16,152. Start date of the fund is defined as the earlier of:

• the date the member joined the fund;
• the start date of a rollover benefit received by the fund;
• the start date with an employer that has contributed to the fund. If Selena made a lump sum withdrawal of $100,000, the tax-free component would be increased by $100,000 x 10,012 / 16,152 = $61,986.13. This would be added to Selena’s existing tax-free component if she had any. The remainder of the withdrawal is the taxable (taxed) component.

Note: When taking a lump sum, specify that your client is taking a disability lump sum and request the increased tax-free component.

Table 1 illustrates a range of lump sum super withdrawals for Selena.

Table 1

Lump sum super withdrawal	Increased tax-free component	Taxable component	Maximum tax payable (22%)	Net benefit if maximum tax applied	Net benefit if Selena has no other income
$100,000	$61,986	$38,014	$8,363	$91,637	$96,481
$250,000	$154,965	$95,035	$20,908	$229,092	$233,929
$500,000	$309,931	$190,069	$41,815	$458,185	$462,093
$1,000,000	$619,861	$380,139	$83,631	$916,369	$920,279
$1,500,000	$929,792	$570,208	$125,446	$1,374,554	$1,378,463
$1,750,000	$1,084,757	$665,243	$146,353	$1,603,647	$1,607,556

Commencing an account-based pension

If Selena commences an account-based pension:

• the tax-free portion of her pension payments are tax free;
• the taxable portion of her pension payments are included in her assessable income and taxed at personal marginal tax rates;
• a 15 per cent tax offset applies against the taxable portion;
• she must take at least the minimum pension payment, and there is no maximum pension payment;
• investment returns on assets supporting the pension are tax-free; and
• upon turning age 60, all pension payments will be tax-free and the 15 per cent tax offset ceases.

Selena has the option of commencing an account-based pension either with her existing super fund or with a new account-based pension provider. Table 2 outlines the pros and cons of either option.

Table 2

Commence an account-based pension with:	Pros and Cons
Existing super fund	Pros: The fund already has Selena’s medical evidence and can commence a disability account-based pension, attracting a 15 per cent tax offset on the taxable component. If Selena’s policy was acquired before 1 July, 2014, additional medical evidence may be required. There may be capital gains tax advantages. For a super master trust, there could be a super to pension transfer bonus. This represents a return of tax provisioning for unrealised capital gains, as the assets will no longer be disposed in accumulation phase. Similarly, assets in a super wrap will not be disposed in accumulation phase. The capital gains tax advantages are more important for non-insurance super benefits, as they have been invested for longer.
	Cons: The increased tax-free calculation may not be applied to the commencement of the account-based pension. This may result in a negative tax outcome.
New account-based pension provider	Pros: The tax-free component of the rollover is increased using the same formula for a disability lump sum. Selena’s new components will be $1,084,757 tax-free and the balance of $665,243 taxable (taxed). This may significantly reduce the tax payable on pension payments. Selena should ensure that a disability rollover is requested with an increased tax-free component.
	Cons: The new fund will require medical evidence and must determine that Selena is permanently incapacitated to commence a disability pension, attracting a 15 per cent tax offset. Some funds provide an indicative decision** prior to receiving the rollover. The CGT implications of leaving the existing upper fund must be considered, e.g. CGT payable for a super wrap or loss of super to pension transfer bonus for a super master trust.

** Some funds allow the medical evidence to be provided prior to receiving the rollover and provide the member with an indicative decision as to whether they would satisfy permanent incapacity. For funds that do not allow an indicative decision, you could make a small rollover to the fund and then apply for a decision.

Consider the transfer balance cap

The transfer balance cap is a limit on how much super can be used to commence a super retirement income stream. As Selena has never commenced a super retirement income stream, the maximum Selena could take as an account-based pension is $1.7 million (the general transfer balance cap for financial year 2021/22).

Lump sum capital requirements may be better taken as a pension payment

For a client under preservation age, lump sums for large one-off expenses may be more tax effective taken as an account-based pension payment or a combination of a pension payment and lump sum super withdrawal. This is because the 15 per cent tax offset for a disability account-based pension exceeds the tax offset, to reduce the maximum tax payable for a lump sum to 20 per cent where taxable income is $120,000 or less, as illustrated in Table 3.

Note: If a member already has $120,000 in taxable income, then only a lump sum may be preferable. Alternatively, consider deferring to a later financial year, if financial circumstances will change.

Table 3

Personal income tax thresholds (resident)	Personal marginal tax rate#	Tax offset if taken as a pension payment	Tax offset if taken as a lump sum withdrawal (under preservation age)^	Highest tax offset – lump sum or pension?
$0 – $18,200	0%	15%	0%	Pension
$18,201 – $45,000	19%		0%
$45,001 – $120,000	32.5%		12.5%
$120,001 – $180,000	37%		17%	Lump sum
$180,000+	45%		25%

 ^# Medicare levy and Medicare levy surcharge may also apply.

^ Tax offset received to reduce maximum tax rate payable to 20%.

To target $120,000 of taxable income with a pension payment, apply the formula:

($120,000 – other taxable income) / taxable (taxed) per cent of the account-based pension

Any additional capital requirements can be taken as a lump sum or deferred to a later financial year.

If Selena commenced an account-based pension with an increased tax-free component, her tax-free and taxable (taxed) percentage would be approximately 62 per cent and 38 per cent respectively. If she had no other income, she could draw up to $315,789 ($120,000/38%) as a pension payment, resulting in a taxable pension payment of $120,000 and a  tax-free pension payment of $195,789. Table 4 compares taking a lump sum only with a pension payment, or combination of pension and lump sum.

Table 4

Withdrawal	Net benefit if 100% taken as a lump sum	Net benefit if using pension**/lump sum			Increased net benefit with pension/lump sum
		Pension/Lump sum		Net benefit
$100,000	$96,481	Pension     $100,000	$99,240		$2,759
		Lump sum $0
$250,000	$233,929	Pension     $250,000	$241,930		$8,001
		Lump sum   $0
$500,000	$462,093	Pension     $315,789 Lump sum $184,211	$470,718		$8,625
$1,000,000	$920,279	Pension     $315,789	$928,904		$8,625
		Lump sum   $684,211

 ** Disability account-based pension with increased tax-free calculation applied.

What if a Selena also makes a personal tax-deductible super contribution?

At the previous 30 June, Selena had a total super balance of less than $500,000, allowing her to use her $30,000 unused concessional contributions amounts accrued since 1 July, 2018.

If Selena claims a tax deduction for personal super contributions of $57,500 in 2021/22 ($30,000 plus the standard annual cap of $27,500), this allows her to draw an additional account-based pension payment of $151,315 ($57,500 /38%) – a total pension payment of $467,104 ($151,315 plus $315,789).

The taxable pension payment is $177,500 and the tax-free pension payment is $289,604. Table 5 compares the total tax payable if Selena draws a pension payment of $315,789 or $467,104 and making a personal tax deductible super contribution.

Table 5

	$315,789 pension payment	$467,104 pension payment
Tax-free/taxable	Tax-free $195,789 Taxable $120,000	Tax-free $289,604 Taxable $177,500
Personal tax deductible super contribution	$0	$57,500
Taxable income	$120,000	$120,000
Tax on taxable income	$29,287	$29,287
Pension tax offset	$18,000	$26,625
Net tax	$11,287	$2,662
Medicare	$2,400	$2,400
Contributions tax	$0	$8,625
Total tax (incl contributions tax and Medicare)	$13,687	$13,687
Available capital	$302,102 ($315,789 – $13,687)	$404,542 ($467,104 – $2,662 – $2,400 – $57,500)

By using a personal tax-deductible super contribution and increased pension payment, Selena has paid the same total tax, but has increased her available capital by $102,440. 

Caution:

• The $57,500 personal contribution must be received by the super fund on or before 30 June, 2022.
• Selena must comply with the timing requirements for the notice of intent to claim a tax deduction for personal super contributions.
• If a lump sum withdrawal is also made, it may result in Division 293 tax (up to an additional 15 per cent tax on super contributions). If Division 293 tax applies, combining pension payments and a tax-deductible super contribution may be detrimental. 

Centrelink considerations

If Selena’s level of disability or illness qualifies her for Centrelink’s disability support pension, commencing an account-based pension may impact her entitlement.

For Selena, the balance of the account-based pension is assessed as an asset and deemed under the income test, whereas, super in accumulation phase is not assessed until attaining Age Pension age. The tax advantages of the account-based pension must be compared with the impact on Centrelink entitlements.

We could start an account-based pension targeting the lower asset threshold ($270,500 for a single homeowner) for Selena, allowing her to maximise Centrelink benefits and tax-free investment returns on the assets supporting her account-based pension.

If Selena already has assessable assets of $30,000, combined with the personal tax deductible and account-based pension strategy, she could commence an account-based pension with $707,604 ($467,104 + $270,500 – $30,000). The $467,104 pension payment can be taken as an annual up-front payment and placed in a redraw account to reduce her housing debt.

Note: Account-based pensions commenced from 1 January, 2015, are deemed for Centrelink income support payments. The actual account-based pension payment is not assessed as income.

She can redraw on these funds to supplement her income needs and make the $57,500 personal tax deductible super contribution. Selena’s account-based pension balance will reduce to $240,500 after the pension payment, resulting in assessable assets of $270,500.

Even with deemed income on the account-based pension of $4,339, she would be entitled to the maximum pension entitlement when she qualifies for the disability income support pension. We could reduce the commencement value of the account-based pension if we wanted to create a buffer for potential investment returns.

Selena cannot use a mortgage offset account, as this would be assessed as an asset and deemed under the income test for Centrelink’s income support payment.

Conclusion

Managing TPD insurance proceeds paid into a super fund for someone under preservation age is complex, but don’t get caught by the misconception that lump sum capital requirements should be received as a lump sum super withdrawal.

Pension payments, or a combination of lump sum and pension payments, may deliver a better tax outcome for your client. Spreading these strategies across multiple financial years may be used to access capital tax effectively. This is especially relevant where advice is being provided close to the end of the current financial year.

Make sure that you know your client’s super product and the steps required to obtain an increased tax-free component before they take a lump sum or commence an account-based pension. Missing out on the increased tax-free component could have severe tax implications for someone aged under 60.

Appendix

The table below illustrates the tax implications and commonly used condition of release across various age groups.

Age	Taxation of lump sum1	Taxation of pension payment	Common condition of release
Less than preservation age	Tax-free component – Tax-free2. Taxable (taxed) component – included in assessable income and taxed at a maximum 20% plus Medicare levy.	Tax-free portion – Tax-free2. Taxable taxed portion – included in assessable income. A 15% tax offset applies where commenced as a disability pension.	Permanently incapacitated.
Preservation age to less than age 60	Tax-free component – Tax free2. Taxable (taxed) component – included in assessable income and taxed at 0% up to available low rate cap (max $225,000 2021/22), thereafter included in assessable income and taxed at a maximum 15% plus Medicare levy.	Tax-free portion – Tax free2. Taxable taxed portion – included in assessable income. A 15% tax offset applies (regardless of whether commenced as a disability pension or not).	Permanent retirement.
From age 60	Tax-free.		Permanent retirement or cessation of a gainful employment arrangement on or after age 60.
At least age 65	Tax-free.		Age 65 retirement condition of release is satisfied.

 ¹ Assumes taxable (taxed), no taxable (untaxed). Lump sums paid under the terminal medical condition of release are tax-free.

² The tax-free component may be increased for a disability lump sum or rollover.

Scott Quinn is Senior Technical Services Manager at IOOF.

***

QUESTIONS

To answer the following questions, go to the Learn tab at moneyandlife.com.au/professionals

1. How much tax is payable on a lump sum super withdrawal for someone less than preservation age?

1. 22 per cent.
2. Taxed at a maximum of 17 per cent including the Medicare levy.
3. The taxable portion is taxed at 20 per cent plus Medicare levy.
4. The taxable portion is included in the individual’s assessable income and taxed at a maximum of 20 per cent plus Medicare levy.

 

2. Alistair (age 41) receives a taxable salary continuance benefit of $132,000 per annum. He wishes to reduce his housing debt by taking benefits from his disability account-based pension. The increased tax-free calculation has already been applied and will not apply again to a lump sum withdrawal. How should Alistair take the additional benefits?

1. As a superannuation lump sum.
2. He should try to get better returns in super than his interest rate on his home loan.
3. Increased pension payment, as he cannot draw a lump sum until he satisfies a condition of release.
4. Combination of lump sum and pension payments.

 

3. Bali (age 36) has $29,000 of taxable income. She has satisfied the permanent incapacity condition of release and wishes to take $400,000 from her super fund. Based on a tax-free percentage of 59 per cent, what combination of disability pension payment and lump sum disability benefit will derive the best tax outcome?

1. $292,683 as a pension payment and $107,317 as a lump sum withdrawal.
2. $154,237 as a pension payment and $245,763 as a lump sum withdrawal.
3. $400,000 as a lump sum withdrawal.
4. $221,951 as a pension payment and $178,049 as a lump sum withdrawal.

 

4. Which statement is incorrect?

1. There may be capital gains tax advantages with commencing an account-based pension with the existing super fund.
2. The increased tax-free calculation will always apply when commencing a disability account-based pension with an existing super fund.
3. Medical evidence must be provided to the new super fund to commence a disability account-based pension.
4. Some funds may provide an indicative decision prior to any super benefits being rolled over.

 

5. If Selena (from the case study in the article) has no other income and wants to access $250,000, then which statement is correct?

1. The best outcome Selena can get is a net benefit of $233,929.
2. By drawing a combination of pension and lump sums, Selena would get an increased net benefit of $8,001, compared to drawing a lump sum super withdrawal.
3. By drawing a $250,000 disability pension payment, Selena would get an increased net benefit of $8,001, compared to drawing a lump sum super withdrawal.
4. Selena should take $120,000 as a disability pension payment and $130,000 as a lump sum super withdrawal.