Life and total permanent disability insurance
Using super for income protection insurance
Chapter 4- Using money in superannuation
LIFE AND TPD INSURANCE
In addition to providing for a member’s retirement, benefits in super funds can be used to purchase certain types of life insurance (sometimes known more generally as ‘risk insurance’).
Many, if not all, managed super funds offer various forms of life insurance. Given the generally-tax advantaged nature of super, these forms of life insurance can often be cheaper to the member. What’s more, if the person wanting insurance is already a member of a particular fund, the new policy can be relatively easy to establish.
As a general proposition, premiums for total and permanent disability (TPD) cover and death cover are not deductible in the hands of individuals paying directly for these types of insurance. That is, if a person purchases these policies directly, the person cannot offset that premium against their income when calculating their tax liability. However, if the policy is held by the person’s super fund the member effectively receives a tax benefit. This is because the contributions that were paid into the fund to finance the insurance premiums are taxed at just 15%.
Let’s look at an example: Wendy has a marginal tax rate of 30%. She has to pay an insurance premium of $1000 to get the required level of life and TPD cover. If she pays this premium directly to the insurer, she does not get a tax deduction. This means she must first earn $1,420 in order to afford the premium. Of this $1,420, she pays 30% in tax – or $420. This leaves her with $1,000 to pay the premium.
If Wendy pays this premium via a super fund, she only needs to earn $1,170 pre-tax. If she contributes $1,170 into her super fund, the fund will pay $170 of this to the tax office has tax ($170 is 15% of $1170). Her super fund is then left with $1000, with which it purchases the insurance policy.
From Wendy’s point of view, she has had to earn $250 less in order to purchase the insurance ($1420 minus $1170 equals $250). Pre-tax, the insurance is $250 cheaper when bought through super.
This tax effectiveness is not the only benefit of using superannuation to finance life insurance. As we outlined above, superannuation is effectively a form of forced saving for one’s retirement. This means that money held within superannuation cannot be withdrawn until a person reaches retirement age. People who need life insurance are typically younger than retirement age. For example, parents of young children who are financially dependent on their parents typically need life insurance. And parents of young children are typically well below retirement age.
Because money held within superannuation is not available to pre-retirees anyway, using superannuation benefits to purchase life insurance means that the individual does not have to use their current disposable income to make the purchase. This can be very advantageous, because the need for life insurance typically arises at the same time as there are many claims on a person’s disposable income. Again, the most common example is a parent of dependent children. Dependent children are expensive, which can make it very difficult for a parent to forego day-to-day spending money in order to purchase life insurance.
What a paradox: the very reason you need life insurance makes life insurance particularly difficult to afford!
Of course, if superannuation benefits are used to purchase life insurance, then there will be fewer benefits remaining when the person eventually retires. If a person wishes to restore their superannuation balance, then this can be a simple matter of either increasing the level of contribution in the current or future years, or deferring retirement for a period of time and using the extra time in the workforce to facilitate increased contributions into super. Deferring retirement also has the advantage of shortening the period of time over which superannuation benefits need to be spent.
Sometimes people argue that using superannuation to purchase life insurance reduces the amount available for retirement. This is not actually true. If using superannuation to finance insurance makes that insurance cheaper in pre-tax terms, and a person must be better off financially when they do so. They are better off to the extent of the tax benefit that they receive. If a person were to save the tax benefit, then their total retirement savings – which includes personal money as well as superannuation benefits – are actually greater than they would be if they had paid the premium directly. (The problem is, most people do not save the tax benefit!)
For these reasons, most people should at least consider using superannuation to purchase non-deductible life insurance.
USING SUPER FOR INCOME PROTECTION
While it makes sense to use super to purchase death cover and TPD, it can make less sense to use super to purchase income protection insurance. There are a few reasons for this. Firstly, premiums for income protection insurance are typically deductible in the hands of the person being insured. This means that if the insured person’s marginal tax rate is greater than 15%, then the tax deductibility for their insurances will be greater if they take at the insurance in their own name. A higher tax deduction means a lower effective cost for the insurance.
If we return to the example of Wendy again, let’s imagine that she’s going to pay $1000 per year to purchase an income protection policy. If she purchases the policy through her superannuation fund, her fund will need to pay $1000. The fund then gets a tax refund of 15%, or $150, meaning her balance has fallen by $850.
Wendy’s personal marginal income tax rate is 30%. If she pays $1000 directly to the insurer, she can claim a tax deduction equal to 30% of $1000. She receives $300 back from the tax office, meaning that her insurance has only cost her $700 in after-tax terms.
But tax deductibility is not the only reason that paying for income protection insurance within super can be a bad idea. When a super fund owns an insurance policy, any payments made under the policy are actually paid into the superannuation fund. In order for the member of the fund to receive the benefits, the super fund needs to be allowed to release the money to that member. In the case of a death or a total and permanent disability, the rules for the release of superannuation benefits are typically met (although there can be a little bit of a grey area when it comes to total and permanent disability). But when it comes to income protection, it is quite possible that the preservation rules within superannuation (the rules that prevent people removing money until they retire) will prevent a member from accessing the insurance payment. This is illustrated in the following story, which we initially published as a blog during 2016.
You may have come across this heart-breaking (and very frustrating) story recently. The story involves a father whose one year old daughter needs a liver transplant. Being so young, the liver does not need to be very big and, thanks to the wonder of our age, she is able to make use of a small piece of her father’s liver.
Unsurprisingly, Dad is more than happy to oblige. But having part of your liver removed is not a small procedure, and he needs to take three months off work. He has an income protection policy which should kick in after 30 days, and he was anticipating receiving a payment of 75% of his income for the second and third months that he is off work.
But there is a hitch. His income protection is held through super, which means that the insurance is paid to the super fund. Any payment to the man constitutes a withdrawal of benefits from the super fund. And the fine print for his fund says that he cannot access such funds in cases of ‘elective surgery.’
Which, in strict legal terms, this surgery is. The strict, narrow interpretation of elective surgery is surgery that will not save your life. In this case, there would be no harm to the Dad if he did not have the surgery. The transplant will save his daughter’s life, not his.
This is, of course, poor form from the institutions concerned. Few people would see anything elective about a parent undergoing surgery that saves their child’s life. But it also underscores the importance of having your risk insurances properly organised. Super can be a good source of finance for some forms of risk insurance, but not for all of them. It is for precisely this reason that it is important to speak to an adviser before proceeding with risk insurances.
From the looks of this article, it seems the negative publicity that comes from having the media involved will lead to a better outcome for the client. This is our other point: sometimes, insurers need to be handled assertively. Our AFSL holder, Dover Financial Advisers, has significant experience in representing clients who have been treated unfairly by their insurer. So, if you or any other person you know has been treated unfairly by your insurer, let us know and we will see if we can get you a better outcome.