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By Scott Quinn, Senior Technical Manager
When helping your clients to adequately prepare for their future, total and permanent disability (TPD) insurance adds a layer of financial protection should your client suffer a permanent injury or illness, making it impossible to return work.
Holding TPD insurance inside super is a common strategy to manage the affordability of the insurance premiums. Many advisers are aware of the increased complexity this presents including the common need to increase insurance cover, the options to fund the premiums and explaining the impact on a client’s retirement savings.
Also, what happens after the insurance proceeds are paid into the member’s super account? And, how do you, as a financial adviser, help your clients manage these funds?
Commonly, the member (your client) will require a substantial portion of this as a lump sum to fund large, one-off expenses like debt clearance, home and car modifications, mobility aids. Plus, they will need an ongoing income stream for day-to-day living expenses.
A common misconception is that lump sum capital requirements should be taken as a lump sum super withdrawal. We’ll explore why this may not be the case.
Selena, who is 38 years old, took a life and TPD insurance policy within her taxed super fund 4 years ago. She has just received a TPD claim and insurance proceeds of $1.5m was paid into her super fund.
The TPD insurance proceeds are not taxable to the super fund and form part of the taxable (taxed) component, bringing her super fund balance up to $1.75m, all taxable (taxed).
The start date of her super fund is 20 May 2004, she stopped being capable of being gainfully employed on 12 March 2021 and her 65th birthday will be on 8 August 2048.
Note: Different rules apply to clients of at least preservation age, outlined in the table in the Appendix.
As Selena’s policy was acquired by her super fund on or after 1 July 2014, the policy terms and conditions must be aligned with the super conditions of release. Her member benefits (including the insurance proceeds) should appear as unrestricted non-preserved, indicating that they can be accessed (as a lump sum and/or income stream) by Selena at any time.
If Selena’s policy was acquired by her super fund before 1 July 2014, the policy terms and conditions may not align with the super conditions of release. The insurance proceeds are only accessible if Selena can satisfy a condition of release, which is generally permanent incapacity for someone less than preservation age (age 60 for Selena).
A super fund trustee is usually satisfied that a member is permanently incapacitated where two doctors have attested that the member is unlikely, because of ill-health (physical or mental) to engage in gainful employment for which they are reasonably qualified by education, training or experience.
If the member benefits (including the insurance proceeds) do not appear as unrestricted non-preserved benefits in their super account, the member or their adviser should contact the super fund to determine whether the original evidence provided for the insurance claim is sufficient to satisfy the permanent incapacity condition of release. If not, the member or their adviser will have to complete the appropriate permanent incapacity form for the super fund to be able to make the super benefits (including the insurance proceeds) accessible.
If Selena withdraws a lump sum, the tax-free component is tax free. The taxable (taxed) component is added on top of her assessable income and where it falls across the 32.5%, 37% or 45% marginal tax rate, a tax offset applies (12.5%, 17% and 25% respectively) to reduce tax payable to a maximum of 20% (plus Medicare levy).
A common misconception is that any lump sum requirements should be accessed as a lump sum, this could lead to an adverse tax outcome.
If Selena withdraws a lump sum, it will qualify as a disability lump sum resulting in an increased tax-free component, calculated by:
days to retirement
Amount of benefit x ____________________________________________
(days from start date to last retirement date)
When taking a lump sum, specify that your client is taking a disability lump sum and request the increased tax-free component.
Table 1 illustrates a range of lump sum super withdrawals for Selena.
If Selena commences an account-based pension:
Selena has the option of commencing an account-based pension either with her existing super fund or with a new account-based pension provider. Table 2 outlines the pros and cons of either option.
*Some funds allow the medical evidence to be provided prior to receiving the rollover and provide the member with an indicative decision as to whether they would satisfy permanent incapacity. For funds that do not allow an indicative decision, you could make a small rollover to the fund and then apply for a decision.
The transfer balance cap is a limit on how much super can be used to commence a super retirement income stream. As Selena has never commenced a super retirement income stream, the maximum Selena could take as an account-based pension is $1.7m (the general transfer balance cap for financial year 2021/22).
For a client under preservation age, lump sums for large one-off expenses may be more tax effective taken as an account-based pension payment or a combination of a pension payment and lump sum super withdrawal. This is because the 15% tax offset for a disability account-based pension exceeds the tax offset, to reduce the maximum tax payable for a lump sum to 20% where taxable income is $120,000 or less, as illustrated in Table 3.
To target $120,000 of taxable income with a pension payment, apply the formula:
($120,000 – other taxable income) / taxable (taxed) % of the account based pension
Any additional capital requirements can be taken as a lump sum or deferred to a later financial year.
If Selena commenced an account-based pension with an increased tax-free component, her tax-free and taxable (taxed) percentage would be approximately 62% and 38% respectively. If she had no other income, she could draw up to $315,789 ($120,000/38%) as a pension payment, resulting in a taxable pension payment of $120,000 and a tax free pension payment of $195,789. Table 4 compares taking a lump sum only with a pension payment, or combination of pension and lump sum.
*Disability account-based pension with increased tax-free calculation applied.
At the previous 30 June, Selena had a total super balance of less than $500,000 allowing her to use her $30,000 unused concessional contributions amounts accrued since 1 July 2018.
If Selena claims a tax deduction for personal super contributions of $57,500 in 2021/22 ($30,000 + standard annual cap of $27,500), this allows her to draw an additional account-based pension payment of $151,315 ($57,500 /38%), a total pension payment of $467,104 ($151,315 + $315,789).
The taxable pension payment is $177,500 and the tax free pension payment is $289,604. Table 5 compares total tax payable if Selena draws a pension payment of $315,789 or $467,104 and making a personal tax deductible super contribution.
Tax free $195,789
Tax free $289,604
By using a personal tax-deductible super contribution and increased pension payment, Selena has paid the same total tax but has increased her available capital by $102,440.
If Selena’s level of disability or illness qualifies her for Centrelink’s disability support pension, commencing an account-based pension may impact her entitlement.
For Selena, the balance of the account-based pension is assessed as an asset and deemed under the income test, whereas, super in accumulation phase is not assessed until attaining age pension age. The tax advantages of the account-based pension must be compared with the impact on Centrelink entitlements.
We could start an account-based pension targeting the lower asset threshold ($270,500 for a single homeowner) for Selena, allowing her to maximise Centrelink benefits and tax free investment returns on the assets supporting her account-based pension.
If Selena already has assessable assets of $30,000, combined with the personal tax deductible super contribution and account- based pension strategy, she could commence an account-based pension with $707,604 ($467,104 + $270,500 - $30,000). The $467,104 pension payment can be taken as an annual up front payment and placed in a redraw account to reduce her housing debt. She can redraw on these funds to supplement her income needs and make the $57,500 personal tax deductible super contribution. Selena’s account-based pension balance will reduce to $240,500 after the pension payment, resulting in assessable assets of $270,500.
Account-based pensions commenced from 1 January 2015 are deemed for Centrelink income support payments, the actual account-based pension payment is not assessed as income.
Even with deemed income on the account-based pension of $4,339 she would be entitled to the maximum pension entitlement when she qualifies for the disability income support pension. We could reduce the commencement value of the account-based pension if we wanted to create a buffer for potential investment returns.
Selena cannot use a mortgage offset account as this would be assessed as an asset and deemed under the income test for Centrelink’s income support payment.
Managing TPD insurance proceeds paid into a super fund for someone under preservation age is complex, but don’t get caught by the misconception that lump sum capital requirements should be received as a lump sum super withdrawal.
Pension payments or a combination of lump sum and pension payments may deliver a better tax outcome for your client. Spreading these strategies across multiple financial years may be used to access capital tax effectively. This is especially relevant where advice is being provided close to the end of the current financial year.
Make sure that you know your client’s super product and the steps required to obtain an increased tax-free component before they take a lump sum or commence an account-based pension. Missing out on the increased tax-free component could have severe tax implications for someone aged under 60.
The table below illustrates the tax implications and commonly used condition of release across various age groups.
Tax-free component – Tax free2.
Taxable (taxed) component – included in assessable income and taxed at a maximum 20% plus Medicare levy.
Tax free portion – Tax free2
Taxable taxed portion – included in assessable income. A 15% tax offset applies where commenced as a disability pension.
1 Assumes taxable (taxed), no taxable (untaxed). Lump sums paid under the terminal medical condition of release are tax free.
2 The tax-free component may be increased for a disability lump sum or rollover.
If you have any questions, or would like more information, please contact the IOOF TechConnect team on 1300 650 414.
The information in this section of the website is intended for financial advisers only and is not to be distributed to clients. It has been prepared on behalf of Australian Executor Trustees Limited ABN 84 007 869 794 AFSL 240023, IOOF Investment Management Limited ABN 53 006 695 021 AFSL 230524, IOOF Investment Services Ltd ABN 80 007 350 405, AFSL 230703 and IOOF Ltd ABN 21 087 649 625 AFSL 230522 based on information that is believed to be accurate and reliable at the time of publication.