Holding insurance inside a risk-only fund can be an attractive proposition, especially when it comes with a 15 per cent rebate if funded via rollover. Could choosing this option end up costing your clients more than they would save?

The cost of insurance is one reason many people consider holding their insurance inside their superannuation. A popular strategy is to use an insurer’s risk-only super product, particularly when a 15 per cent rebate becomes available to members when they fund their premiums by rolling over part of their existing super balances.

When insurance is held inside super, trustees can claim a tax deduction on the premiums they pay for Life Insurance, TPD and Income Protection, thereby reducing their fund’s taxable income (which would otherwise be taxed at 15 per cent). The benefit of this deduction is generally passed back to members as an offset against tax that was applied to their account balance in the financial year the deduction was claimed.

However, in risk-only funds, because rollovers between taxed super funds aren’t assessable as income, the benefit of this deduction is passed back as a 15 per cent premium rebate. Yet while such a rebate can sound appealing, opting for this over the alternative – namely, of housing cover in a platform fund/SMSF – could end up costing your clients more than it appears to be saving them.

Grossing up the cost of premiums

Grossing up the cost of premiums can help your clients understand how different funding options can affect the benefits of holding insurance in super. For example, let’s say Terry and Shona both have life insurance policies in a risk-only fund, for which they each pay $5,000 in annual premiums.

Shona pays the annual premium by making a personal super contribution via BPAY. She provides a valid Notice of Intent (NOI – also known as section 290-170 form) to the trustee and claims the deduction in her tax return once she’s been advised it’s been accepted.

This means that the gross cost of $5,000 insurance premiums to Shona’s pre-tax income is $5,000[i]. As the super fund can claim a tax deduction for the premium, the 15 per cent contributions tax on the personal deductible contribution is effectively offset, meaning it will cost Shona exactly $5,000 to fund the premium inside her super. Thus, the contribution doesn’t have to be grossed up to account for the 15 per cent contributions tax.

By contrast, Terry pays his annual premium by direct debit and doesn’t claim a deduction for his personal super contribution. Terry’s taxable income is $130,000. As amounts over $120,000 are taxed at 39 per cent (including a 2 per cent Medicare levy), the gross cost of Terry’s $5,000 insurance premium to his pre-tax income is $8,196.72[ii]. This is because Terry is paying for his premium with after-tax dollars, which costs him $3,196.72 more than if he paid with pre-tax dollars.

If either Shona or Terry had their cover in a risk-only fund, and paid for their premiums by way of rollover from another super fund, they would only need to rollover 85 per cent of their premiums (as the 15 per cent rebate would be available). However, it is worth noting that the fund would have levied a 15 per cent contributions tax on this rollover amount in their original super fund if the amount was sourced from a concessional contribution. Thus, the end premium cost to Shona or Terry would be the same regardless of which funds they held their respective covers in (i.e. risk-only vs. retail fund/platform fund/SMSF, etc.).

This example shows that funding premiums from pre-tax contributions (for example, by making personal deductible and salary sacrifice contributions) isn’t only tax effective but provides that all-important top-up to super balances to counter the effect of premium erosion on retirement savings.

The importance of reviewing your clients’ super components

When considering whether to fund insurance premiums by rollover to receive the 15 per cent rebate, the various components of your clients’ existing super should also be reviewed. When a partial rollover occurs, both taxable and tax-free interests in a super account are drawn down proportionately. Accordingly, consideration should be given to the gross cost of the components that may be rolled over.

For instance, let’s say $300,000 of your client’s $600,000 balance is tax-free and they receive a $750 rebate on their $5,000 premium. A rollover is processed for $4,250, which includes a tax-free component of $2,125. Assuming the taxable component was taxed at 15 per cent, and that the tax-free component was taxed at your client’s marginal tax rate, the gross cost of the premiums to your client after the 15 per cent rebate could be as follows:

^*Includes 2 per cent Medicare Levy.

⁺Income at the time non-concessional contributions were made.

Weighing up the benefits

It’s important to review the components of your clients’ super balances when comparing the benefits of a 15 per cent rebate against the potential impacts of partial rollovers. And it’s not just the tax-free component that should be considered; other components that may require further review include (though aren’t limited to):

• unrestricted non-preserved amounts
• UK pension components, and
• taxable components that include an untaxed element.

Thus, if clients already have a super fund and require cover, consider whether their wealth protection objectives could be met by housing their cover within their existing platform fund/SMSF. Unlike a rollover, the payment of the premium from the member’s account won’t dilute the tax-free component and will instead be drawn entirely from the taxable component, thereby keeping the tax-free component intact.

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This information is intended for financial advisers only and is not for wider distribution. This information is current at the date of distribution and is subject to change. This is general information in summary only, without taking into account the objectives, financial situation, needs or personal circumstances of any individual, and may not be exhaustive. It is not intended as financial, legal, taxation, medical or other advice.

[i] When a valid NOI is received, the trustee generally withholds 15 per cent tax as the contribution is then classified as a concessional contribution. In a risk-only fund, no tax is withheld in lieu of the deduction the trustee can claim on the insurance premiums.

[ii] Although non-concessional contributions aren’t taxable income to the super fund in a risk-only fund, the tax benefit isn’t passed back. This is because individuals may provide a valid NOI later and the amount claimed would become taxable income to the super fund.