Jennifer Brookhouse explains why TPD premiums may become less effective inside super
A common strategy to reduce the effective cost of total and permanent disability (TPD) insurance premiums is to hold the policy inside superannuation.
However, this strategy may become less effective from July 1, 2011. This gives advisers a year to provide new advice to affected clients and, in some cases, move the insurance out of superannuation. If legislation is not passed to ensure this change applies only from 2011, the reduced deduction could be backdated to July 1, 2004.
Reducing the cost of premiums
Superannuation is commonly used to allow a client to cost effectively pay for life insurance premiums. The cost of premiums is reduced through a combination of salary sacrifice (or personal tax deduction for contributions) and the ability for the trustee to claim a tax deduction for the premiums to offset the contributions tax. This is shown in the diagram below.
If the trustee passes on the value of the tax deduction directly to the client, tax is not deducted from the contribution.
The new interpretation of legislation
Changes to legislation wording on July 1, 2007 highlighted a problem with the full deductibility of TPD premiums. This issue has been in dispute for the past two years. The Australian Taxation Office (ATO) is sticking to its position that the new wording did not change the rules, and its current interpretation – that TPD premiums are not always fully deductible – should have applied since July 1, 2004.
Temporary relief is proposed to allow the industry time to make adjustments and to avoid backdating. If legislation is passed, TPD premiums will remain fully deductible until July 1, 2011, but from that date the circumstances around the policy need to be examined to determine how much of the premium is deductible. The current interpretation is that the TPD premiums will be deductible only to “the extent the policies have the necessary connection to a liability of the fund to provide disability superannuation benefits to their members and not other types of insurance for which premiums are collected from their members”.
In simple terms, this means that if the TPD policy definition matches the Superannuation Industry Supervision (SIS) permanent incapacity release definition, the full premium is likely to be deductible. However, the premium for policies with other definitions, such as “own occupation”, may only be partially deductible or potentially not deductible at all.
The changes are proposed to apply from July 1, 2011, but this may have immediate implications for advice strategies to determine whether policies should:
- be selected with disability definitions that are likely to maintain the full deductibility, or
- be moved outside superannuation by July 1, 2011.
Adviser action – impact on advice
Legislation to defer the new interpretation to July 1, 2011 has not been passed, so advisers should keep abreast of the developments to assess the final outcome.
Unless the ATO concedes to any further changes, advisers will need to consider the following steps.
1. If TPD is recommended inside superannuation, review the policy definitions to determine which policy is most suitable for the client and consider the taxation implications.
2. If the TPD premium is not fully deductible, the benefits of holding the policy inside superannuation compared to a non-superannuation TPD policy may reduce. For some clients, the advantages inside superannuation may no longer offer sufficient value and they may wish to transfer to a non-superannuation policy.
3. Clients with TPD insurance inside a self- managed super fund (SMSF) will need to determine whether the premiums are tax deductible.This may require an actuarial calculation.
4. Statements of advice (SOAs) recommending clients take TPD inside superannuation should now include a warning about the potential change from July 1, 2011 and the need to review circumstances closer to that date.
5. Review all clients with TPD inside superannuation (especially with policy definitions other than “any occupation”) before July 1, 2011 to notify them of the changes and make any required adjustments to their strategy.
6. If legislation is not passed to start the limited deductibility from July 1, 2011 (and remove the backdating from July 1, 2004) trustees of SMSFs will need to review previous tax returns and determine if they need to be lodged again to reduce the amount of the deduction. The trustees will need to work with their tax advisers.
Transferring insurance policies
While an insurance policy that is owned by a member or a related party cannot be transferred into a superannuation fund, there is no restriction on transferring policies out of a superannuation fund.
Therefore, if it is no longer appropriate to hold a policy inside superannuation, the TPD policy can be transferred to an ordinary non-superannuation policy, unless restrictions are imposed by the life company. Before taking any action you should speak with the insurer to understand requirements and any limitations.