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The type of cover, deductibility of premiums and treatment of claims make life insurance a complex topic for tax.
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Find the right tax strategy for life insurance
15 July 2022
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Accountants are increasingly called upon to advise on the tax treatment of products designed to support or protect the lives of their professional and business clients.
One such product is life insurance, where the deductibility of premiums and treatment of claims payouts can be a complex, nuanced topic.
The opportunities and traps hidden in those complexities are greatly amplified for professionals with higher incomes and greater-than-average wealth.
For professionals who want to structure their life insurances to optimise the balance between cash flow, tax treatment and robust protection, here’s a high-level look at the issues.
Inside v outside super?
One of the biggest decisions to be made is whether to hold cover inside or outside super.
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Under the sole purpose test, superannuation funds can own policies for death, any occupation TPD (explained below) and income protection cover. However, trauma cover is unable to be owned through superannuation and neither are many of the value-added features commonly seen in non-super policies.
There are both tax and cash flow benefits from holding cover through super, although these need to be balanced against the potential taxation of claims, depending on whom benefits are paid to.
Flexibility of life cover outside super
Because life insurance outside super is not subject to the restrictive guidelines of the sole purpose test, a greater number of options are available.
Trauma policies, which cover health events such as cancer, heart attack and stroke (as well as 50+ other conditions) are only available outside super, as is business expense protection and the “own occupation” definition of TPD (where permanent disability is judged against whether you will ever be able to perform your current profession, as opposed to any occupation for which you may be suited).
Similarly, the benefits available under income protection policies held outside super are also less restricted, allowing such policies to offer a lot more value-added features.
Tax considerations – cover outside super
While premiums for death, TPD and trauma cover are not tax-deductible outside of superannuation, premiums for income protection and business expenses protection are.
On the flip side of that, claims payments from death, TPD and trauma policies are completely tax-free, regardless of whom they are paid to, while income protection and business expense benefits are classed as income and need to be declared (business expenses payments would naturally offset the actual expenses they are intended to cover).
Special tax treatment of policies held for business purposes
Some tax concessions are available to life insurance policies held for business purposes, including buy/sell agreements and those covering revenue lost in the event of the death or disablement of a key person.
In such cases, policies are generally held by the business with premiums tax-deductible to the business. However, claim payments are generally regarded as income or a capital gain, depending on the purpose of cover, and therefore subject to appropriate tax. FBT can also apply where a business pays ownership protection premiums on behalf of individual owners.
Life insurance inside super
For an individual holding life cover permitted through super, there are a number of tax benefits and concessions that can apply.
First, for individuals who would ordinarily be able to claim their personal superannuation contributions as a tax deduction (for example the self-employed), then any contributions made to a super fund (including risk-only super funds) for the purpose of paying life insurance premiums – and within contribution caps – would be deductible to the individual.
For those unable to claim their personal super contributions as a tax deduction (most employees), there are still other tax benefits available. For example, the trustees of many risk-only super funds pass back any tax concessions they receive, resulting in a 15 per cent rebate on rollovers made to pay premiums (effectively meaning 15 per cent cheaper cover).
The main driver for taking life cover through super is the cash flow benefit, and for employed professionals with substantial balances and higher-than-average premiums, the cash flow benefits of paying premiums out of super balances – rather than out of pocket – can certainly be very appealing.
This appeal does of course need to be balanced against the fact that risk premiums will erode the superannuation savings balance, while contributions to a risk-only super product still count towards contribution caps. As always, the right strategy will vary from individual to individual.
Insurance in SMSFs
For the growing number of professionals owning SMSFs, it should be remembered that SMSFs can generally claim life insurance premiums for members as a deductible expense to the fund.
Strategies to optimise disablement cover for professionals
As mentioned earlier in this article, one important consideration for professionals is the inability to obtain the superior own occupation TPD cover through superannuation.
In response to this, many life insurers offer the ability to link together a non-super TPD policy offering own occupation cover with a super-based policy offering any occupation TPD and death cover.
Under this approach, the bulk of the coverage, and thus the premiums, are through superannuation, and thus enjoy the same tax and cash flow advantages described above. The added advantage of linking the covers together is that the own occupation portion of the policy is charged at linked or rider rates, which can be substantially lower than stand-alone rates.
Tax on life claims paid through super
Death benefits paid through super are generally tax-free if paid to a dependent (a term strictly defined under law). Benefits paid to non-dependents may include a tax-free component but are likely to be subject to tax on at least some of the balance. Depending on the circumstances, the applicable rate will either be 15 or 30 per cent.
With TPD lump sum benefits, a portion is likely to be assessed as tax-free, dependent on the member’s eligible service period, with the remainder subject to a tax rate that varies according to the member’s age.
Other tax-optimising strategies include taking benefits as an income stream to qualify for tax offsets, maximising the uplift in the tax-free portion of the benefit, and washing out taxable components.
Summary
The complexities around the tax treatment of life insurance present both challenges and opportunities, especially for highly qualified, high-earning professionals. Qualified financial advisers are uniquely placed to ensure their clients navigate these complexities in a way that optimises their coverage and tax and cash flow positions.
Brian Pillemer is director of distribution at PPS Mutual.
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