Macquarie Adviser Services

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1 14 Macquarie Adviser Services

2 tech talk Written by David Shirlow, Head of MAStech, Macquarie Adviser Services Super TPD reinvented in a post-reform world In the last few months we have seen a number of clarifications of the tax treatment of insurance and related superannuation benefits, including: the 13 October 2009 announcement by Chris Bowen, Minister for Superannuation, on the deductibility of total and permanent disablement (TPD) insurance premiums for superannuation fund trustees several Australian Taxation Office (ATO) private rulings and interpretative decisions on when and how an additional tax free component may be calculated for disability benefits ATO views on which member accounts insurance proceeds should be added to. These clarifications come on the back of comprehensive changes to the tax treatment of superannuation with the Better Super reforms in 2007, which stimulated quite a bit of new commentary about client insurance strategies. In this article we ll explore some of the recent clarifications in the context of a case study focused on TPD benefits. Incidentally, advisers who want to explore the relative appeal of insuring inside of super for life, disability income and trauma insurance as well as TPD cover may be interested to know that we have produced a broader guide called The ins and outs of insuring through super. It focuses on super and tax law implications and is available to those who have access to the MAStech Technical Library. Read this story to receive a CPD point. Simply log on to macquarie.com.au/ftmagazine 15

3 Macquarie Adviser Services Toby and the straightforward case of any occupation TPD insurance Take the case of Toby who is 45 years old, on the top marginal tax rate and wants $600,000 net TPD cover. If he wants what is typically referred to as any occupation TPD cover then the position can be relatively straightforward. That is because proceeds payable under this type of insurance can typically be paid as disability superannuation benefits for tax purposes and released immediately by a super fund trustee on the grounds of permanent incapacity. General rule of thumb In circumstances where there is immediate access to the benefits and the super premiums are fully deductible (but non-super premiums are not deductible), the alternative ways of funding this type of cover generally rank as follows in terms of lowest pre-tax cost: 1. concessional contributions to super (CCs) within the client s cap 2. non-concessional contributions to super (NCCs) within the client s cap 3. outside of super. This is the case notwithstanding that there will typically be tax payable on a benefit paid from the super fund (at an effective rate of up to 21.5%). A full description of the reasoning and underlying assumptions is set out in the broader guide referred to earlier. Also, interested advisers who have access can model specific scenarios with the MAStech Insurance Tax Calculator, drawing comparisons in particular client scenarios. Exception: credit for deduction? If the super fund does not credit the client with the value of the deduction for the insurance premium then funding TPD cover outside of super will be more tax efficient than funding it via super NCCs (but not super CCs). If Toby were to have an accumulation or pension account in the same super fund as the one in which he proposes to establish his insurance arrangement, then typically you might expect the fund trustee to credit his account with the value of the premium deduction it will receive. Be aware, however, that stand-alone super insurance arrangements will typically not credit the deduction to the account where premiums are paid with NCCs. Exception: lengthy service period? The taxation of TPD benefits paid from super is dependent on the client s service period - that is, the longer the service period, the greater the tax liability. In a limited number of cases some clients with very long service periods (e.g. those age 51 to 55 who have service periods starting before age 29) may find that insuring TPD through super using NCCs is not as attractive as insuring outside super. But again, CCs are typically more tax efficient regardless of the service period. Proceeds taxed in the hands of the super fund trustee? Some commentators have expressed concern about the possibility of TPD insurance proceeds being taxable at the super fund level. The ATO have clearly indicated in minutes of recent NTLG meetings that it will continue (as per Tax Determination TD14) to treat the proceeds as exempt. Further, to the extent that there is uncertainty arising from the current wording of the relevant CGT provisions, we note that Treasury is exploring options to resolve this. 16

4 tech talk Toby wants own occupation TPD one problem becomes two Let s assume instead that Toby wants own occupation insurance given his profession and background. Problem No. 1 immediate access to the benefit The key drawback of holding own occupation TPD insurance inside super is that, in the event of a claim being paid, there is a risk that the benefit will not be able to be released to him immediately, because the nature of the disability may not meet super law requirements for release. This can be a significant practical problem, particularly for someone under the age of 55. Some commentators have canvassed the view that it would be rare for super fund trustees to decide that they could not pay own occupation policy proceeds out of the fund. We note, however, that own occupation TPD cover premiums are typically around 50% higher than their any occupation counterparts. In our view, this is a reasonable reflection of the level of risk of own occupation insurance proceeds being trapped in the fund (i.e. about a 1 in 3 chance for a member under the age of 55). Also, the inference drawn from some commentaries is that SMSF trustees are more likely to pay out such benefits immediately than others. We simply note that SMSF trustees are subject to the same SIS payment standards as other fund trustees. Problem No. 2 future partial loss of tax deduction On 13 October 2009 the Minister for Superannuation, Chris Bowen, announced transitional TPD premium deduction rules for the 2009/10 and 2010/11 years. In effect this heralds the partial removal of deductibility of own occupation TPD cover for superannuation fund trustees from 1 July 2011 which will be an additional disincentive to hold these policies inside super. Own occupation TPD solution for Toby one policy becomes two One solution to these problems is to restructure own occupation insurance arrangements so that the part of the cover which is fully deductible and meets the super law benefit conditions of release is held inside super (i.e. the part which is broadly equivalent to any occupation cover) and the balance of the own occupation cover is held outside of super. This split-cover approach has been pioneered by Macquarie Life, which launched its Super Optimiser product solution in May this year. Dual policies - the tax efficiencies The Super Optimiser approach provides full access to benefits in a tax efficient way. If instead Toby were to insure outside super the benefit would be immediately accessible in the event of a claim being paid, but the premium would not be deductible so the pre-tax cost would be much higher. Alternatively, if he were to insure completely inside super and became disabled soon after, there is the risk that any claim proceeds would not be accessible for about 10 years, which for Toby is unacceptable. Also, in establishing his insurance arrangement, he needs to bear in mind that although in the current year 100% of the premium will be deductible, from 1 July 2011 he can expect that typically only about 66% of the premium will be deductible. Under a split-cover approach such as Super Optimiser, his fund will hold the fully accessible benefit cover inside super and claim a full deduction for it, and hold the balance of the cover in a separate non-deductible policy in his own name. Each policy will cover a separate range of disability events, but the combined effect is that he will be covered for own occupation TPD. The total cover needs to be increased to around $646,638 to allow for any tax payable on payment of the benefit out of the super policy in the current year, but this will still be substantially cheaper for Toby than insuring outside of super once all tax considerations are taken into account. This is particularly the case if the premium payments are sourced from concessional contributions (within his CC cap). 17

5 Macquarie Adviser Services Additional tax free component lightens the tax on TPD benefits Aside from removing reasonable benefit limits from the tax equation, the 2007 Better Super reforms retained (indeed, slightly extended) the scope for clients to receive disability superannuation benefits which attract an extra tax free component. Broadly, when a superannuation lump sum is a disability superannuation benefit, a tax free component can be calculated. This is in addition to any tax free component that may already exist in relation to the lump sum. As Toby s case demonstrates, there are quite a number of strategic considerations both at the time the insurance is arranged and once benefits become payable. In Toby s case he already has $40,000 tax free component in his accumulation account because he has made a total of $40,000 of nonconcessional contributions over the years. His total accumulating benefit stands at $200,000. What is a disability superannuation benefit? Assume Toby becomes totally and permanently disabled soon after the insurance is taken out. His superannuation benefit may qualify as a disability superannuation benefit if the following conditions are satisfied: 1. the benefit is paid to him because he suffers from ill-health (whether physical or mental); and 2. two legally qualified medical practitioners have certified that, because of the ill-health, it is unlikely that he can ever be gainfully employed in a capacity for which he is reasonably qualified because of education, experience or training. Toby provides the trustee of his fund with the requisite certificates and requests that all his benefit be cashed immediately as a lump sum. The trustee is satisfied that his benefit can be released on the grounds of permanent incapacity and is a disability superannuation benefit for tax purposes (noting that the definition of permanent incapacity has similarities with the definition of disability superannuation benefit ). Let s say Toby joined the fund on 1 October 1999 and that was the date his service period started. The trustee calculates the additional tax free component as follows (refer to the break-out box for background information on the calculation): Amount of benefit = $200,000 accumulated plus $646,638 insurance proceeds Days to retirement = 7,282 Service days = 3,676 The additional tax free component is therefore $562,623; i.e. $846,638 x 7,282/ (3,676+ 7,282). So the total tax free component will be $602,623 (i.e. $562,623 plus $40,000), with the balance of the benefit ($244,015) being taxable component. 18

6 tech talk Calculating the additional tax free component The additional tax free component is generally calculated as follows: Amount of benefit where: x days to retirement service days + days to retirement days to retirement is the number of days from the day on which the person stopped being capable of being gainfully employed to his or her Iast retirement day (often the client s 65th birthday); service days is the number of days in the service period for the lump sum. The service period is typically the period starting from the day the relevant client joined the fund that is, the period of fund membership. Service period exceptions: However, the period may start on an earlier day in the following circumstances: rollovers: the benefit is (at least partly) attributable to an earlier benefit which has been rolled over into the current fund and it had an earlier service period, the service period of the current benefit will generally be calculated from the first day of the service period of the rolled over benefit; standard employer-sponsored fund arrangements: in many cases the service period will be calculated from the first day of employment with a relevant employer. Note that the employment period is not taken into account in calculating the service period for some superannuation fund arrangements. Does insuring in a new super fund arrangement affect this? If Toby had recently joined a second fund and his insurance was arranged in that fund, then (unless a service period exception applies see break-out box) his service days would have started on that date and he would only have a small number of service days. His additional tax free component would therefore be quite close to 100% of the total insured benefit. This would result in a higher portion of the benefit being tax free, so a lower level of cover would be required to provide an after tax cover level of $600,000. In Toby s case, if Toby joined a new fund on 1 October 2009, he would need only $600,406 of TPD cover. In these circumstances the total benefit would not include his existing accumulation benefit (comprising $40,000 tax free and $160,000 taxable components) as we re assuming it remains in the first fund. What if Toby delays receiving part of his benefit? Let s revert to our previous scenario where Toby has all his super in one fund when he becomes disabled. Say Toby only withdraws $100,000 of the total benefit of $846,638. In this instance, the $100,000 would be treated as a disability superannuation benefit and $66,454 of it would be additional tax free component alongside the existing tax free component. (The existing tax free component is calculated under the tax component proportioning rule and comes from the non-concessional contributions he made). He has met the permanent incapacity condition of release in respect of the whole of his benefit entitlements so the $746,638 which remains in the fund is now classified as unrestricted nonpreserved component. 19

7 Macquarie Adviser Services Five years (i.e. 1,826 days) later the benefit has grown to $1 million. He decides to withdraw only the $700,000 unrestricted non-preserved benefit. In circumstances such as these the ATO accepts that, as the funds being withdrawn are only unrestricted non-preserved benefits because the member has satisfied the permanent incapacity condition of release, there is sufficient causal connection between the condition of release being satisfied and the later lump sum being paid. Therefore, the benefit can be regarded as a disability superannuation benefit and the additional tax free component can apply to the lump sum (see ATO ID 2009/109). It is interesting to note that where there is a delay between the date of disability and the date of benefit payment, as is the case here, the days between those two dates get double-counted in the denominator of the calculation equation. That is, they count as service days as well as days to retirement. While the delay reduces the proportion of the benefit which will classified as additional tax free component, the benefit may have grown during that time. What if he had wanted to withdraw the whole $1 million? In these circumstances he would need to meet a suitable condition of release to withdraw the growth of $253,362, because it would be classified as preserved. And if he wanted to ensure that the additional tax free component could be calculated for that whole benefit he would need to satisfy the trustee afresh that he was permanently incapacitated, again having regard to two medical certificates. In these cases, unless there is evidence suggesting that a member s circumstances have changed since the payment of the first lump sum (for example, in relation to the nature of the disability, the lapsing of time, or the member s education, experience or training), the ATO accept that the trustee is able to rely on previous certificates for this purpose (see ATO ID 2009/108). In Toby s case, depending on the nature of the initial disability, it is possible that the time lapse of five years is a significant enough for the trustee to require fresh medical certificates. Pensions and rollovers with TPD benefits What if Toby starts a pension with the TPD proceeds? Of course, given that Toby has satisfied the permanent incapacity condition of release, he may withdraw his unrestricted non-preserved benefit at any time as an account-based pension rather than as a lump sum. An income stream paid in the event of permanent incapacity attracts a 15% rebate regardless of the age at which taken, except if the client is aged 60 or more in which case the pension payments are not subject to tax at all. If Toby s pension was started in the fund which received the TPD insurance proceeds, the ATO considers that there would be no additional tax free component included in the calculation of the tax component percentages of the pension (see ATO ID 2009/125). What if Toby rolls over his disability superannuation benefit? However, different (and perhaps unintended) results can occur if, instead of cashing a benefit, Toby rolls it over to a new fund. Assuming the amount rolled over qualifies as a disability superannuation benefit, it will include the additional tax free component calculated on the basis described above. If Toby starts a pension in the new fund its tax component percentages will reflect the additional tax free component. And if he cashes the benefit as a lump sum having provided the requisite medical certificates to the new fund trustee, there is an argument that the additional tax free component will be calculated again, causing a double-up of additional tax free amounts clearly an unintended consequence! (The calculations will need to reflect up-to-date variables in the equation.) What if Toby was already in pension phase when the insurance claim was paid? Now let s assume instead that, before he became disabled, Toby was already age 55 and had commenced a pension. 20

8 tech talk Interestingly, if Toby had paid the insurance premiums paid out of his pension account, then the ATO s general view is that the TPD proceeds would be added to that account. All benefits paid from the pension account will generally have fixed tax free and taxable component percentages which were set at the commencement of the pension. This means that the TPD proceeds, when they are ultimately paid out of the pension account, will also have those tax free and taxable component percentages. If the tax free component percentage is very high, then this may produce a more favourable result than if the insurance had been funded from Toby s accumulation account (and vice versa). This may be the case, for example, if Toby s pension account had been funded predominantly with non-concessional contributions. Of course, once Toby turns 60 all benefits become non-assessable non-exempt income. Making the most of super TPD treatment While insuring against disability inside super isn t suitable for all clients, for many clients there are clear tax efficiencies in at least partially doing so. As Toby s case demonstrates, there are quite a number of strategic considerations both at the time the insurance is arranged and once benefits become payable. The following tools, available to advisers with MAStech library access, are designed to help you work through some of these considerations in structuring your clients insurance arrangements: The MAStech Insurance Tax Calculator is a tool that compares life and TPD cover outside and inside super. It allows you to calculate the gross up required to cover super lump sum tax, and compare the pre-tax or after-tax costs of premiums outside or inside super. The ins and outs of insuring through super booklet (the broader guide referred to earlier in this article) provides a brief analysis of the tax and access issues associated with insuring inside versus outside super and identifies a number of rules of thumb as to the circumstances in which super or non-super arrangements may suit particular categories of clients. Macquarie Life product innovations The superannuation rules discussed in the article above have led us to explore more efficient ways for clients to arrange their insurances. Some examples are listed below. 1. Super Optimiser TPD insurance, as discussed in the article, allows own occupation TPD to be split so that the part of the cover which is fully deductible and meets the super law benefit conditions of release is held inside super (i.e. the part which is broadly equivalent to any occupation cover) and the balance of the own occupation cover is held outside of super. The Super Optimiser approach provides full access to benefits in a tax efficient way. 2. Super Protector Disability Income Insurance (DII) - TPD commutation option. The existence of more favourable tax settings and benefit options under super law in the event of permanent incapacity as compared to temporary incapacity is one of the reasons the Super Protector DII policy provides an option that enables clients who have become permanently incapacitated as defined in the PDS to have the option to commute their DII income benefits. This enables them to receive a tax efficient lump sum or an account-based pension. 3. Super Protector DII Extra Benefits policy. The availability of certain ancillary benefits is limited through super due to the sole purpose test and rules of release, therefore Macquarie allows the core DII cover to be held within super and the ancillary package of extra benefits to be held outside of super. n 21