TAX CONSIDERATIONS FOR OWNING TPD POLICIES INSIDE OR OUTSIDE SUPERANNUATION

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1 1 Rahul Singh, ANZ Technical Services Manager at ANZ, Singh has been in the industry for 11 years in a number of financial planning roles with the last eight years in technical services. His current role involves assisting financial planners with delivering advice to their clients on matters such as retirement planning, social security, aged care and taxation. He is particularly passionate about developing strategies which strengthen and promote value of advice. TAX CONSIDERATIONS FOR OWNING TPD POLICIES INSIDE OR OUTSIDE SUPERANNUATION Rahul Singh Prior to 1 July 2014, when considering total and permanent disablement (TPD) insurance, advisers typically considered the advantages and disadvantages of owning the cover inside or outside superannuation when deciding the ownership structure. The advice considerations usually related to access to insurance proceeds, including limitations placed by SIS conditions of release, tax, differences on claim definitions and cashflow concerns. Often, the advice led to a solution which favoured an all or nothing approach TPD cover entirely either inside or outside superannuation. Legislative changes that came into effect from 1 July 2014 for insurance in superannuation aligning insurance definitions to superannuation conditions of release helped precipitate product innovation. While different terms are used in the industry split TPD, flexible linking, SuperLink many products now allow TPD cover to be held inside superannuation with insurance definitions aligned to any occupation but also having the same amount outside of superannuation with insurance definitions based on own occupation. This kind of ownership structure allows the client to get the best of both worlds of structuring TPD inside or outside superannuation. From this point on, we refer to this arrangement as SuperLink. Let s use a case study when comparing the use of SuperLink policies to a stand-alone outside super TPD policy, particularly focussing on the tax implications. Further reference to a superannuation based TPD policy is defined as risk only super plans (without any accumulation). Consider this case study John (35) is an IT Systems Manager earning $120,000 per annum. He is married to Mary (33), who is working part-time earning $37,000 per annum. They have two young children under the age of 5. They have a mortgage of $400,000. He is covered for 75% of income replacement to age 65 through income protection cover held outside super. To replace the other 25% of John s income, ancillary costs and immediate lump sum needs, you have quantified the TPD insurance needs to be $1.5 million. After paying down debts, $1.1 million will be invested to provide income. While recognising any insurance solution is incomplete without adequate life and trauma cover, we have scoped out these components of protection and focussed our attention on TPD insurance. How should we structure the insurance inside or outside superannuation? Stand-alone non-superannuation based TPD policy Favourable claim policy definitions Non-superannuation based TPD policies can be paid out on the basis of inability to work based on the life insured s own occupation. The claim definitions are generally easier to meet as the insured is assessed against their occupation compared to definitions which are based on an inability to work in any occupation. Access to own occupation definitions however, come with a trade-off such policies usually incur higher premiums compared to policies based on any occupation definition. For example, using OnePath OneCare policy, premiums on an own occupation policy are 40% more than a policy based on any occupation.

2 2 Where the policy is held through superannuation, the claim definition is based on inability to perform any occupation. Policy definitions solely based on inability to perform activities of daily living or loss of body parts is not available through superannuation. Relevant to any occupation through superannuation, OneCare PDS states a claim may be paid where as a result of illness or injury, the life insured: a. has been absent from and unable to work for three consecutive months b. is disabled at the end of the period for three consecutive months to such an extent that they are unlikely ever again to engage in any occupation for which they are reasonably suited by their education, training or experience. Taxation considerations There are two taxing points to consider: 1. upon receiving the proceeds 2. subsequent investment of those proceeds Upon receiving the proceeds Lump sum payment from a TPD policy taken out for a non-business purpose is not ordinary income it is a tax-free capital payment. Congruently, the payout is exempt from capital gains tax as the proceeds are received by the person insured. Subsequent investment of the proceeds This aspect requires further thought. One significant planning point would be the choice of investment structure once immediate lump sum costs have been spent. John continues to receive $90,000 (75% of $120,000) from the income protection policy up to age 65. For each $1 of income above $87,000 but less than $180,000, his marginal tax rate is 39% (including 2% Medicare Levy). Comparing John and Mary s marginal tax rates, it would be tax-inefficient for the investment to be owned by John. Instead, it makes sense for the investment to be owned by Mary, given her lower marginal tax rate, providing tax savings on the taxable income. For illustration and simplicity, we assume that the proceeds are invested entirely in fixed interest. The below table compares the tax position of the investment generating 3% taxable income: Contributing to superannuation to improve the tax savings With taxable income in accumulation phase being taxed at a maximum of 15% and pension phase 0%, superannuation could be used as a tax-effective investment structure to provide income. We note that under the proposed changes from 1 July 2017, commencement of a disability income stream is viewed as a credit against the $1.6 million transfer balance cap. With John having minimal other superannuation savings, he is unaffected by this proposal given the amount he wants to start an income stream with is less than $1.6 million. Contributing to superannuation is limited by non-concessional contribution caps. Assuming the Government s proposal to reduce the non-concessional contributions cap is legislated, from 1 July 2017, John can contribute up to $300,000 of non-concessional contributions using the bring-forward provisions. Prior to committing to making the contribution, there are a few things that John would need to appreciate. Preservation Any contribution made to a super fund is initially preserved. To have access to the funds or have the ability to commence a disability income stream, John would need to meet the permanent incapacity condition of release. While he has already received a payout from a non-super TPD policy, one cannot automatically assume that he would satisfy the superannuation permanent incapacity condition of release particularly if the trigger for the payout was based on John s own occupation. To achieve some certainty with future planning and prior to making the contribution, some super funds allow pre-approval, whereby all the relevant paperwork, including medical documentation is provided to the super trustee before making the contribution. The trustee then makes an undertaking whether the superannuation permanent incapacity condition of release has been met allowing clarity on preservation issues. Even if the trustee doesn t have a process to pre-approve whether the permanent incapacity condition of release is met, one could consider making a small contribution and testing out the trustee s view to facilitate larger contributions within the contribution caps. Non-concessional contribution caps The non-concessional contribution cap presents an obstacle in immediately getting the $1.1 million to superannuation. We wish to maintain a cash reserve of $100,000. Assuming the proposal to reduce the non-concessional contribution cap is legislated and we want to get $1 million into superannuation, it would take at least 8 financial years using the bring-forward provisions to get the entire amount into superannuation. For completeness, it wouldn t be tax efficient for the entire investment to be owned by the children as they are under 18 and subject to punitive tax rates. That said, if the savings are used for the children s benefit, they could consider investing sufficient capital to stay within the minor s $416 tax-free threshold. Given they have two kids, investing a capital amount of $13,866 each generating 3% taxable income, could provide a further tax saving of $287 per annum ($832 X 34.5%). Medical documentation If a decision is made to contribute to superannuation, there may be a question whether the documentation provided for the non-super claim may be used to certify permanent incapacity condition of release to the super trustee? This is likely to depend on the super

3 3 fund s administrative rules while recognising that the requirements may be less onerous if the same organisation is involved. The need to obtain new medical documentation introduces another layer of administrative burden on the client and their expectations may need to be managed around the need for new medical documentation. SuperLink policies As discussed earlier, SuperLink TPD policies allow insurance to be owned inside superannuation on any occupation basis while also linking the sum insured to outside superannuation on an own occupation basis. The sum insured is the same amount for the TPD component inside and outside superannuation. Further, upon claim, TPD component inside superannuation is assessed first and tested against the superannuation based definition of permanent incapacity. Where the superannuation definition is not met, the claim is assessed against the non-super based claim definitions. From a planning perspective, while it may be useful to have the ability to cherry pick the basis for which the insurance is paid, this is left to circumstances the nature of the person s illness or injury and satisfaction of definitions will determine whether the proceeds are paid out from inside or outside super. While SuperLink TPD policies allow the client to take advantage of best of both worlds, that is all the advantages of TPD coverage inside and outside super, there are a few things to consider. Premiums The premiums for a stand-alone non-super TPD and SuperLink policy are identical. However, differences arise in terms of how they are funded. Using OnePath OneCare insurance policy, non-superannuation TPD and SuperLink policy costs $1,027 per annum. The breakdown of the SuperLink $1,027 premium is apportioned as $714 per annum as premium for TPD inside superannuation and $313 per annum as premium for non-superannuation component. The outside superannuation based premium of $313 must be paid from private savings. Accumulated superannuation savings or contributions cannot be used to fund the non-super component. Given identical premiums for both types of policies, there are a few considerations regarding suitability of either structure: cashflow constrained clients tax-effectiveness of paying for the super linked premiums potential access to tax-effective superannuation based payment options Cashflow constrained clients Some clients will raise the affordability issue. For these clients, while not completely alleviating the affordability issue, a SuperLink policy can assist. John can use his existing superannuation savings to fund the superannuation component of the policy, being $714. This can be done, depending on product functionality, including but not limited to rollovers from an external fund or through Superannuation Guarantee contributions (for employees). The issue remains of funding the non-superannuation component of $313 (as opposed to $1,027 for a stand-alone non superannuation TPD policy) which must be funded from non-superannuation monies. While not completely alleviating concerns of a cashflow strapped client, it nonetheless lowers the amount that needs to be funded directly by the client. Where superannuation monies are used to fund insurance premiums, guidance from ASIC Report 413: Review of retail life insurance advice should be considered in ensuring that the client understands the depleting effect it has on retirement savings and has considered making contributions to pay for the premiums. Tax-effective payment of premiums One of the main attractions of owning TPD through superannuation is the tax concessions on paying for the premiums. Non-super TPD policy $1,027 has to be taken from John s private savings to pay his nonsuper premiums. Hence, the after tax cost is $1,027. SuperLink TPD policy $313 has to be taken from John s private savings to pay for the nonsuperannuation component of his SuperLink policy. The superannuation component of $714 can be funded by salary sacrifice. As the super fund claims a deduction for the premium, there is no contributions tax paid on contributions equal to the premiums. The $714, if funded through salary sacrifice, John s after-tax income is reduced by $435 [$714 X (1-39%)]. The after tax cost of funding the policy is $748 ($313 + $435). This is favourable compared to a stand-alone non super TPD policy by $279 ($1,027-$748). Potential access to tax-effective superannuation based payment options With a stand-alone outside superannuation TPD policy, to use the tax benefits of the superannuation structure, a consideration was to make non-concessional contributions to get the proceeds into superannuation. With a SuperLink TPD policy, where the cover is paid out on the super based policy, the insurance proceeds are paid to the trustee of the super fund and initially recorded as taxable component. The member can then start a superannuation account based pension. Minimum pension payment standards are required but there is no restriction on how much can be drawn. 15% tax offset on the taxable portion of the pension payments applies if 2 legally qualified medical practitioners have certified that, because of the ill-health, it is unlikely that the individual can ever be gainfully employed in a capacity for which he or she is reasonably qualified because of education, experience or training. Tax on lump sum withdrawal If the claim is successful based on superannuation definition of permanent incapacity, then the $400,000 lump sum needed to extinguish the mortgage would incur superannuation lump sum tax.

4 4 The quote Where the superannuation definition is not met, the claim is assessed against the nonsuper based claim definitions. If John was to receive a lump sum before he attains his preservation age (for him age 60), he would be liable for a maximum rate of 22% on the taxable component. However, the tax rules provide him with an increased tax-free component based on days to retirement and his service period in the fund upon him receiving a disability lump sum. The increased tax-free calculation is calculated as: Amount of benefit X [days to retirement / (service days + days to retirement)] Days to retirement: number of days from the day on which the person stopped being capable of being gainfully employed to their last retirement date (usually 65th birthday). Service days: number of days in the service period for the lump sum Going back to John, if he had the TPD event on his 40th birthday and his service period in the fund was 10 years, the increase tax-free component would be calculated as following: $400,000 X (9,132 / 3, ,132) = $285,687 This means that out of the $400,000 withdrawal, $285,687 will consist of the tax-free component and $114,313 will be the taxable component. No tax is paid on the tax-free component and 22% maximum tax is paid on the $114,313. Therefore, $25,149 tax is paid on the $400,000 withdrawal meaning that the net payment for a $400,000 withdrawal is $374,851. John would need to withdraw $426,836 to ensure that he receives $400,000 net of tax. Due to the operation of the increased tax-free component formula as described above, the effect of the service period on resultant tax components is important to understand. Where premiums are funded through external fund rollovers, if the transferring fund has an earlier service period, the receiving fund would inherit the earlier service period. This may result in lower recalculated taxfree component and therefore increase the tax payable on any disability lump sum benefit. Consideration should be given to grossing up the sum insured to take into account this tax liability to ensure that the sum insured in net terms is sufficient to meet client s goals and objectives. Where the sum insured is grossed up, it will increase the cost of insurance and water down the tax benefits of having a SuperLink policy compared to a stand-alone non superannuation TPD policy. Starting an account based pension Care needs to be taken that the superannuation fund allows a disability account based pension. Some funds, particularly risk only super plans, are lump sum focussed and a disability account based pension may not be an option. Starting an account based pension within the same fund While practice may differ across funds, legislatively, if the account based pension is started partly or wholly within the same superannuation fund, then the account based pension s tax components consist of 100% taxable component. The pension payments will be subject to John s marginal tax rate with a 15% rebate. John being under 65 is required to draw out 4% of the account balance as a minimum pension payment. Assuming he starts the account based pension with $1,073,164 (remainder after the lump sum), minimum pension payment is $42,930 (rounded to the nearest $10 whole dollars). With inclusion of the pension payments along with the income protection payments, his total taxable income is $132,930, with him being on the 39% marginal tax rate. This means he effectively pays $10,303 in tax on the $42,930 pension payments ((39% -15%) X 42,930). Starting an account based pension with a different super fund The tax position on the pension payments could be improved if he starts an account based pension with a different superannuation fund. Upon transfer, the original fund recalculates the taxcomponents describing the details on a rollover benefit statement to the destination fund. Going back to John, if he had the TPD event on his 40th birthday and his service period in the fund was 10 years, the increased tax-free component would be calculated as following: $1,073,164 X (9,132 / 3, ,132) =$ 766,474 This means that out of the $1,073,164 rollover, $766,474 will be the tax-free component and $306,690 being the taxable component. Upon taking a 4% minimum from this fund, the tax components consist of 71.42% tax-free component and 28.58% taxable component. Therefore, only $12,269 of the $42,930 pension payments will be taxable. John is liable for $2,945 in tax (39%-15%) on the pension payments as compared to $10,303 when the account based pension was commenced in the same fund. Starting an account based pension also compares favourably to nonsuperannuation TPD proceeds invested in either Mary or John s name. While starting an account based pension with a different superannuation fund is favourable from a tax perspective, an issue to contend with is whether the original fund transfers the benefits with unrestricted non-preserved status? Many funds, when injecting insurance benefits into the fund that have been paid out on the basis of any occupation typically also make the funds unrestricted non-preserved status. Where they don t do this,

5 5 the new fund will have to be satisfied that the member satisfies the permanent incapacity condition of release, which may require new medical documentation. Even if the original super fund sends the monies with unrestricted non-preserved status, if a 15% tax rebate is needed on the taxable portion of the pension payments, the new fund would need to have received certification from two legally qualified medical practitioners that, because of the ill-health, it is unlikely that the individual can ever be gainfully employed in a capacity for which he or she is reasonably qualified because of education, experience or training. Conclusion While there is no one size fits all approach, from the above case study, the key summary points are: Non-superannuation TPD policy based on own occupation compared to superannuation based any occupation claim definitions may be easier to meet. While no tax is paid on the proceeds on a non-superannuation TPD policy, the investment of the residual TPD proceeds after paying immediate lump sums may not be as tax-effective compared to superannuation based TPD proceeds. SuperLink TPD policies compared to stand alone non-superannuation TPD policies can be funded taxeffectively through concessional contributions. That said, when paid under the superannuation based policy, superannuation benefit taxes bring about an additional layer of complexity to manage. For cashflow strapped clients, SuperLink TPD policies may reduce the amount funded directly from non-superannuation savings, while getting the best of inside and outside super insurance ownership. SuperLink TPD policies, while potentially allowing best of both world, leave it to matter of circumstance in relation to whether the proceeds are paid from the super or non-super based policy. In assessing whether the sum insured is adequate to meet client s goals and objectives, consider grossing up the sum insured to take into account lump sum super taxes when considering SuperLink policies. SuperLink TPD policies, paid on the basis of superannuation definition of permanent incapacity, may allow commencement of disability account based pensions. Where commenced with a different superannuation fund, the increased tax-free component may assist with reducing the tax payable on pension payments. fs The quote Care needs to be taken that the superannuation fund allows a disability account based pension.