Unless we have significant legislative reform to the superannuation rules on temporary incapacity benefits, it will become increasingly rare for disability income insurance (DII) to be arranged through clients’ super funds.
In recent years there have been a series of tax and super law developments that have weighed against holding DII inside of super. And arguably the final straw falls on July 1 this year when Superannuation Industry (Supervision) Act 1993 (SIS) provisions directed at new super fund insurance arrangements come into effect. While there are other considerations that can have a bearing on whether or not to hold insurance inside super – such as the cash-flow appeal of paying premiums out of super – in one way or another these developments may have a telling impact on the decision.
Changes in tax equation
Tax treatment of contributions and premiums: An individual client who effects DII outside of super to protect against loss of their own income is entitled to a deduction on the premiums. This generally means that unless the client can fund DII inside super with non-excessive concessional contributions (CCs), it will be more tax-efficient for the client to hold DII outside of super.
But even clients who can fund their DII super arrangements with non-excessive CCs need to consider whether it is efficient to do so.
First, the super fund trustee will need to be entitled to claim a deduction for the DII premium to neutralise the effect of the 15 per cent fund tax liability on the CC. Having regard to the Australian Tax Office’s (ATO’s) views on relevant provisions arising from the 2007 super tax reform, the availability of a deduction for the whole premium will not be assured where the DII policy benefit design does not match the SIS payment rules (see scenarios, left – click on image to enlarge). If the premium is not wholly deductible, then a better result may be achieved by holding the cover outside of super.
Second, some clients with relevant annual income exceeding $300,000 will personally incur another 15 per cent tax on their CCs, making non-super DII a more efficient option.
Of more widespread significance is the overall reduction of CC caps since July 2009. This has led to a situation where many clients are contributing right up to their CC cap and needing to do so in order to fund for an adequate retirement benefit. Where deductible contributions are being fully utilised for retirement purposes a DII super arrangement will need to be funded by non-concessional contributions or excessive CCs – either way, this is very unlikely to be as tax-effective as funding DII outside of super.
Tax on insured benefits: To complete the tax picture we need to look at the tax treatment of insurance proceeds paid to the super fund trustee in the event of a successful claim and benefits ultimately paid to the client as a fund member.
While there may be some technical complications with the treatment of disability insurance proceeds, current ATO practice is to treat proceeds as non-assessable in the hands of the super fund trustee. Also, the government has recently confirmed it will proceed with a proposal to make technical amendments to ensure non-assessability of proceeds.
That leaves benefits tax to be considered. Each benefit paid from the fund as a “temporary incapacity” benefit for the purposes of SIS is assessable income in the hands of the client. This is effectively the same as the tax treatment of typical DII proceeds paid directly to a client under a non-super arrangement.
If, however, the super DII benefit becomes payable as a “permanent incapacity” benefit for the purposes of SIS then, depending on the terms of the policy, there may be scope to commute benefits to a lump sum attracting disability-related tax concessions and/or receive a superannuation income stream that receives a 15 per cent tax offset prior to age 60 and is tax-free from that age.
So, for some clients at least, when compared with DII non-super arrangements, DII super arrangements can prove to be tax neutral or, in the event of permanent incapacity, tax-favourable.
The final straw?
Beyond tax outcomes, in the absence of careful DII policy design, a new SIS rule is potentially the key obstacle to effecting DII insurance via super. In broad terms, the new rule prohibits trustees of regulated super funds from providing insured benefits not aligned with the SIS conditions of release for death, terminal illness, permanent incapacity and temporary incapacity from July 1, 2014. Insurance cover that is in place for a client prior to July 1, 2014 will not be affected. So, from July, self-managed super fund (SMSF) trustees seeking to effect arrangements for income protection insurance will need to ensure that the benefits provided under the policy are aligned with the relevant SIS conditions, particularly the “temporary incapacity” condition of release.
Unfortunately, there are various aspects of the current SIS provisions on temporary incapacity benefits that are at odds with developments in the design of DII product benefits. To the left are some examples of scenarios in which it would be reasonable to expect a client to be covered under a typical DII policy. However, in the absence of legislative change, there are SIS issues to be grappled with in determining whether the terms of a particular DII policy will enable it to be provided within super.
The future
Various industry stakeholders are in the process of advocating revisions to relevant SIS provisions so as to better facilitate the provision of “best practice” DII benefits via superannuation. It remains to be seen if and when the government will respond to this advocacy.
In the meantime, some DII product providers may, at least to some degree, have found ways to deal with some of the SIS issues described above. However, arguably the only way to deal with all these issues and to ensure comprehensive DII coverage for a client is to have a split-cover arrangement using two policies:
• a super policy that aligns with the SIS limitations, linked with
• a non-super policy providing supplementary cover for benefits that are beyond the SIS limitations.
So, to the extent that the future of DII involving super is foreseeable, it appears to involve split-cover arrangements.
