The premiums for income protection policies are tax-deductible both inside and outside of superannuation. Does this make both options equally tax effective? Or is one option more effective? Legislation was amended in 2007 (Tax Determination TD 2007/3) to extend the tax deductibility of income protection premiums inside a superannuation fund. Trustees are now able to claim a tax deduction for premiums covering a benefit period longer than two years. With this change it was generally acknowledged that super funds were no longer at a tax disadvantage. However, this needs closer examination to see if it holds true.
The decision to hold an insurance policy (any type of policy) inside or outside superannuation should consider a wider range of issues than just taxation. It should also take into consideration cashflow needs of the client and the access and range of benefits available through superannuation. To compare the tax-effectiveness it is important to consider the individual client circumstances. In particular, consider the type of contribution used to fund the premium.
PAYING PREMIUMS WITH SALARY SACRIFICE
Trevor earns a salary of $85,000 per annum plus superannuation guarantee (SG) of $7650 per annum to make a total package of $92,650. This places him on the 41.5 per cent marginal tax rate. He arranges an income protection policy with a premium of $1772* per annum. This premium is tax-deductible. If the policy is held outside super, Trevor pays the premium from after-tax salary and claims a tax deduction of $1772 in his tax return. The tax deduction reduces his tax payable by $735.
If Trevor instead salary sacrifices $1772 into super to pay the premium, no tax is paid on this contribution as the trustee claims a deduction to offset the contributions tax and passes on this deduction fully to Trevor. This means the premium is effectively paid from tax-free income. The table below shows the impact of both options on his financial position. For an employee using salary sacrifice to pay the premiums, holding income protection inside superannuation is tax neutral compared to holding the policy outside.
Trevor effectively receives a tax deduction for either the superannuation contribution or the premium. In both options the tax saving reduces the effective cost of the premiums to make them more affordable. If he makes a claim on the policy, the payments received are taxable income under both options.
PAYING PREMIUMS WITH SUPER GUARANTEE (SG) PAYMENTS
For many clients, the decision to hold income protection inside superannuation may be an affordability, or cashflow, issue rather than a tax one. Inside superannuation, the opportunity exists to use previously accumulated savings or employer SG contributions to pay the premiums. This removes the need to find disposable income to fund the premiums. While this option may make the cover affordable, it may be less tax-effective and come at an overall cost. The salary sacrifice example shows how tax on income can be reduced from the marginal tax rate (in this case 41.5 per cent) to nil.
However, in the case of SG contributions these amounts cannot be converted to cash. Therefore the maximum tax rate on this money is limited to 15 per cent. If Trevor’s only contributions into his fund are SG contributions so that $1772 of these contributions is effectively used to pay the premium, the tax saving is only $266 ($1772 x 15 per cent). This reduces the comparative tax-effectiveness of his overall package.
ACCOUNTING SYSTEMS VARY RESULTS
The above examples both assume that the accounting methodology used by the superannuation fund trustee passes on the full benefit of the tax deduction for the premiums to the individual member as a reduction in contributions tax. This may not happen in all superannuation funds. Superannuation funds operate various accounting mechanisms. The contributions tax is easy to identify at the individual member account level but the tax deduction may not be reconciled at the member level as it is applied to the fund’s total tax return.
Some trustees track the premium deductions to individual members and pass on the full benefit to their account. Other funds may use varying methods such as:
• deducting the full 15 percent contributions tax on all concessional contributions regardless of insurance premiums paid. The deductions reduce tax overall for the fund and help to boost the fund’s effective earnings rate rather than being passed back to the individual member. • netting off concessional contributions ina particular quarter against premiums deducted in that quarter to determine contributions tax payable. This can create a timing mismatch of benefits.
Before making a recommendation to use salary sacrifice to pay the premiums for income protection, advisers should check whether the superannuation fund passes on the tax benefit directly to the member. This is not an issue in a self-managed superannuation fund.
Self-employed professionals may find the option to hold income protection inside superannuation to be more tax-effective than outside superannuation in some circumstances. This occurs if the option for cover inside superannuation allows them to reduce their gross salary and divert theextra income to other more tax-effective structures or strategies.
For example, if Trevor operates a business through a company structure the gross income needed to pay the premium is only $1772 per annum if paid through superannuation compared to $3029 outside superannuation. Instead of paying the extra $1257 as salary this amount could, for example, be retained in his company or be paid through a family trust. Trevor should seek advice from his tax adviser to ensure tax avoidance issues do not arise.
For tax (and therefore cost) effectiveness, unless the client has a cashflow problem and needs to use accumulated savings or employer contributions to pay the premiums, it may be more appropriate to hold income protection outside superannuation. As an additional benefit, a wider range of features is usually accessible on products outside superannuation. Inside superannuation, the range of features and access to the benefits may be limited by rules such as preservation and/or sole purpose test.