Often, when deciding how a client should pay for life insurance, the number one consideration is whether to hold the insurance cover through their superannuation fund and fund the premiums from their superannuation account balance, or to have the client own the policy outside of super. This article considers the nuances and complexities beyond the binary decision to fund insurance from within or outside super.

1. How much super your client has in the first place

This goes to the heart of the regulatory scrutiny over whether retirement savings are inappropriately being eroded by premiums. Paying for insurance from super funds could be detrimental to a client’s retirement savings strategy, especially if contribution caps remain persistently low, and the client’s balance in their super is relatively low.

If insurance is self-owned, more capital remains compounding inside super and a greater proportion of contributions actually augment retirement savings, rather than merely replenishing accounts that have been eroded by premiums. Over time that could make a meaningful difference for clients.

2. Tax and other advantages of paying from non-super funds

Clients who pay for their income protection (IP) cover from their own funds (and not from their super) may be able to receive direct tax deductions for premiums paid.

For example, if a $3,000 premium payable on an IP policy were directly debited from the client’s bank account during the financial year, the ensuing $3,000 tax deduction (if 100 per cent of the premium relates to income-replacing benefits) that the client can claim in their tax return reduces their overall income tax liability, meaning the actual cost of the cover is only $1,830 or $1,590, for a client in the second highest and highest marginal tax bracket respectively. (All calculations include the Medicare levy.)

(Notably, self-funded Life and Total Permanent Disability [TPD] cover for personal risk protection are not tax-deductible.)

To pay for premiums, a client can link a bank account or credit card to their policies. Another option is linking the policies to the platform they are using for investments, with premiums funded from a cash management account on the platform. The main benefit of this funding option for clients is premium discounts usually apply when they choose to set up their policies via a wealth management platform.

Meanwhile, financial planners can administer their clients’ cover more efficiently on the platform. For example, planners can generate insurance reports and sort their clients’ accounts in order of urgency, saving planners time and helping them to act quickly to minimise lapse rates.

A related advantage of self-owning income protection cover may be its use as an employee retention strategy by benevolent employers. An employer can pay for an employee’s self-owned IP policy and claim the tax deduction. If this were done for an employee’s term life, TPD or trauma policy, it would attract a fringe benefits tax liability; not so for income protection, under the otherwise deductible rule. If the employee subsequently leaves the employer, they can assume payment for the policy and claim the appropriate deduction.

As discussed above, an added benefit of self-owning an IP policy is clients’ savings in super are quarantined from IP premium erosion. Instead, 100 per cent of their super can be set aside for retirement and expected to grow, thanks to the effect of compounding.

3. Weigh up the many pros and cons of using super to pay for insurance

Taking out insurance within super remains an attractive option for many clients, particularly if this strategy can make premiums more affordable for clients. The advantages of holding insurance within super are:

• Ease of cash flow

One of the main reasons for holding insurance inside super is cash flow. When held in super, existing accumulated super benefits and employer super contributions can be used to pay for the cost of the insurance, as well as the option to pay an annual premium via a partial rollover, which may attract a discount of up to 15 per cent.

• Claiming a tax deduction for the cost of insurance

When insurance is held within super, clients can generally make tax-deductible contributions into super to cover the premium costs, which can make it more tax effective to hold the cover in super. However, as discussed above, when IP cover is held outside super, the premiums are generally tax-deductible, and therefore they can achieve the same tax outcome.

A spouse or partner may make a non-concessional contribution for their spouse or partner and receive a tax offset of up to $540. The contribution can fund some or all of the receiving spouse or partner’s insurance premium.

• Automatic cover

Many employer super funds provide automatic group insurance cover which provides another benefit of holding insurance in super. In many cases, clients do not make an active choice to commence group cover. For example, default Term Life and TPD cover is usually provided on an opt-out basis, although Putting Members’ Interest First changes mean certain superannuation fund members need to opt-in for insurance cover. However, IP cover, if offered, is more likely to be on an opt-in basis.

Often, group insurance is available through a MySuper account set up by an employer, and therefore, insurance is funded through employer contributions into that fund. Hence, the insured person does not have to actively engage in order to obtain and maintain cover.

• Reduced underwriting

When group insurance is held within super, there is often no underwriting or reduced underwriting. Default cover is available to all people within a specific group, regardless of their health status. A personal statement is not required, and therefore, loadings and personal exclusions do not apply (though blanket exclusions may). As such, clients who would otherwise be unable to obtain retail cover, or would have an exclusion or loading applied to their policy, may choose group insurance as an alternative.

There may also be an automatic acceptance level that is higher than the default level of cover, and therefore, a higher initial sum insured can be secured, without underwriting.

Meanwhile, the disadvantages of holding insurance inside super are:

• Group insurance may only provide a basic level of cover

Group insurance makes up a large proportion of insurance policies that are funded via superannuation. Typically, group insurance is only meant to offer a base level of cover, and because there are restrictions on what can be offered inside super, it may not be as comprehensive as retail insurance.

There will generally be lower maximum sums insured and a lower number of ancillary benefits. TPD cover will usually be linked with Term Life cover, but will not have buy-back options. The cover may also decrease as the insured person ages, which may not align with their needs.

Pre-existing condition exclusions may apply for one or two years, up to the lifetime of the policy. However, the insured person may be unaware of what these are. With retail cover, any pre-existing condition exclusions will be explicitly stated in the policy schedule.

• Restrictions on the types and features of insurance when held inside super

Not all types of life insurance can be held within super. Since 1 July 2014, the Superannuation Industry (supervision) (SIS) regulations have prohibited superannuation funds from providing insurance cover to a member unless the terms and conditions align with one of four SIS conditions of release (death, terminal medical condition, permanent incapacity and temporary incapacity). For this reason, Trauma cover and own occupation TPD cover cannot be purchased within super.

• Insurance benefits may become trapped within super or be offset

Prior to 1 July 2014, there were no such restrictions and all types of insurance could be held within super. If Trauma or own occupation TPD insurance were taken out within super prior to 1 July 2014, they can continue to be held within super. However, if the client makes a claim under these types of policies, the benefit may not necessarily be able to be released from super. In these situations, the benefit will become trapped inside super and the client will only be able to access the benefit once they meet a SIS condition of release, which may not occur until they retire or reach age 65.

IP policies held inside super may be offset by sick leave, annual leave or long service payments to ensure overall payments do not exceed 100 per cent of the client’s pre-disability income. Most group insurance funds fully offset sick leave and Centrelink payments. Retail IP policies generally do not have these offsets.

• Potential tax payable on insurance benefits

There may be tax payable if an insurance benefit is paid out of super, which would not otherwise be payable if the insurance were held outside super. Income protection benefits must be included in the client’s assessable income, whether the IP cover is held inside super or outside super. However, with cover inside super, the super fund trustee deducts the relevant PAYG withholding tax. In comparison, if funding insurance outside super, the policyholder receives a gross payment to be added as income to their tax return.

Death and TPD benefits paid are generally received tax-free when they are held for personal purposes and paid from a policy which is not held within super. If a death benefit is paid from super, and it is paid to a non-tax dependant, such as an independent adult child, the recipient may pay tax of up to 32 per cent on the benefit. If TPD benefits are paid out of super, tax of up to 22 per cent may be payable on the benefit, depending on the age of the client. (Tax rates include the Medicare levy.)

4. Flexi-linking or super-linking

If clients want to hold insurance within super, another option is to consider holding insurance via flexi-linking or super-linking. By doing so, they can hold the insurance in super but also link it to a policy outside super, which then allows them to have all types of cover and also have all the features that can be provided outside of super.

If clients would like to hold trauma insurance or own occupation TPD and pay for the premiums with some of their super, they can consider flexi-linking this type of cover with other cover, for example, linking Term Life cover with TPD own occupation.

Flexible linking builds on the traditional concept of rider policies, but allows the rider to be held outside super. For example, an own occupation TPD or Trauma policy could be owned outside super, but linked to a Term Life policy which is held inside super. This is one of a number of ways flexible linked policies can be structured.

Super-linking is another way that clients can hold policies outside super but pay for most of the premiums from their super account. Super-linking is where a single policy is spread across the super and non-super environment. The portion of the policy that is held inside super is the part that would result in a claim that can be accessed under an SIS condition of release; the portion held outside super is that which cannot. For example, clients seeking to utilise their super to fund insurance premiums can access own occupation TPD using super-linking.

The portion of the TPD policy that can be released from super (the any occupation portion) is owned inside super, and the own occupation portion is owned outside super.

The insured person will first be assessed against the any occupation TPD definition and any proceeds will be subject to potential superannuation lump sum tax on withdrawal. If they do not meet the any occupation TPD definition, only then will the insured person be assessed against the own occupation TPD definition.

With a super-linked policy, the portion of an IP policy that holds benefits releasable from super is owned inside super, with the remainder held outside super. Super-linking also allows for clients to receive their full agreed value monthly benefit even if the monthly benefit is higher than their pre-disability income. If a client ceases work prior to becoming disabled and they hold IP cover inside super which is linked to a policy outside super, the monthly benefit can be paid from the non-super policy.

5. Self insurance options for self-employed or business owners

The recent removal of new ‘agreed value’ IP contracts can make it a challenge to structure IP cover for clients with fluctuating levels of income – typically, those who are self-employed or run a business.

While an indemnity IP policy can provide some cash flow certainty in the event of disability, the actual monthly insured benefit may be of little value if the illness has happened amid, or following, a prolonged slump in business income.

Self-employed clients may wish to self-insure by building up a pool of capital within a company in their group structure, which gives clients access to funds if and when required. Funds could be ‘streamed’ out of the company to qualifying shareholders, which may be the policyholder and/or members of the policyholder’s family group, providing a useful boost to cash flow during a temporary illness. Expert advice would, of course, need to be obtained to determine the impact that this arrangement may have from a tax and claims perspective.

For sole trader clients without elaborate group structures and entities, the pool of capital could be in the name of a lower-income tax paying spouse. A degree of asset protection is also afforded.

For the self-employed who are of (or near) preservation age, another self-insurance option is super. It may be advantageous for a couple to maximise contributions to either of their super accounts where this is not already occurring. Some qualifying clients may even be able to utilise unused portions of the concessional contributions cap. Being of preservation age, the clients may be able to draw funds out via a non-commutable income stream if funds are required to normalise cash flow during a temporary disability.

Conclusion

The right funding solution for life insurance may be different for each client, and it’s important to consider the options that are available, as part of your advice strategy.

Alex Koodrin, Senior Product Manager – Advised, Life Insurance, BT.

Footnotes

1. Treasury Laws Amendment (Putting Members’ Interests First) Act 2019.

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QUESTIONS

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

1. Jack, age 37, is worried about how he will fund his insurance premiums. Jack’s financial planner suggests he consider funding his insurance premiums via a cash management account on the wealth management platform he is using. What is the main benefit to Jack of doing this?

1. Two frequent flyer points for every dollar of premium paid.
2. Insurance reports can be generated.
3. Premium discounts for setting up the policy on the platform.
4. A guarantee that the policy will never lapse.

2. Mary, age 47, is an employee of Z Constructions Company. Mary has worked for the company for 15 years. If the company decides to pay for an income protection policy owned by Mary, who can claim the tax deduction?

2. The employer.
3. The employee.
4. The employer can claim 50 per cent and the employee can claim 50 per cent.
5. Neither, plus fringe benefit tax applies.

3. What are the advantages of holding group insurance inside super?

3. Ease of cash flow.
4. Tax-effectiveness.
5. Automatic acceptance limits.
6. All of the above.

4. Sally is considering her insurance needs. Which of the following types of cover, for personal risk protection, are not tax deductible, if held outside of super?

1. Life cover.
2. Total Permanent Disability cover.
3. Income Protection.
4. Both (a) and (b).

5. What is the maximum potential tax liability on a super-linked TPD policy?

1. None, as a claim would always be paid on the policy outside super.
2. 32%, if it is linked to a term life policy inside super.
3. 30%, if it is held for revenue purposes and owned by a company.
4. 22%, if the insured person meets the SIS permanent incapacity condition of release.