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By Stuart Sheary, Senior Technical Manager
Holding life insurance through super is popular. Reasons for this include its tax effectiveness and reduced impact on your client's personal cashflow if funded by salary sacrifice or employer super guarantee contributions.
The deductibility of super contributions which can fund life insurance in super often translates into greater insurance for the same after-tax cost to your client. The following article explores the merits of holding life insurance through super.
The tax effectiveness of life insurance through super will depend on who will receive the super death benefit and whether the benefit is in the form of a lump sum or income stream.
A spouse can receive a super death benefit in the form of a lump sum or an income stream (subject to their transfer balance cap). The income stream may be taxable depending on the spouse's age, the age of the deceased and the tax component received. These variations are illustrated in the table below.
* The tax free component is received tax free regardless of age.
An adult child is typically restricted to only receiving a super death benefit in the form of a lump sum (an income stream is available if the child is under age 25 and financially dependent on the deceased). The taxable component of a death benefit lump sum paid to an adult child will be taxable unless the child is a financial dependant or in an interdependency relationship (see How the ATO defines an interdependency relationship).
If the intended beneficiary is an adult child your client may prefer to direct the death benefit to the estate and then from the estate to the adult child to avoid the 2% Medicare levy.
The table below illustrates the taxation of a lump sum super death benefit paid to an adult child.
* Tax free component is tax free.
** The amount is added to assessable income. Medicare levy and Medicare levy surcharge may also apply if paid directly.
Holding life insurance through super is particularly favourable when the beneficiary is a spouse as a death benefit lump sum is received tax free and the surviving spouse can receive a death benefit income stream.
The following scenarios illustrate the advantage of holding life insurance through super compared to holding life insurance personally, where the beneficiary is a tax-dependent such as a spouse or non-tax dependant such as an adult child.
Scenario 1 - Holding life insurance for the benefit of a spouse (tax dependant)
Trevor earns a salary of $100,000 a year and is on a marginal tax rate of 34.5% (including Medicare levy). He needs approximately $750,000 in life insurance however due to cashflow constraints he is only able to pay an annual premium of $1,250. This amount will buy him $500,000 in life insurance.
If Trevor is willing to forgo $1,250 of after-tax income to finance life insurance and has available concessional contribution cap space, he can make an annual personal deductible super contribution up to $1,9081. This will put him in the same after-tax cashflow position, after taking into account the available tax deduction. This personal deductible contribution can fund an annual premium of $1,908 and can purchase $763,300 in insurance within super.2
^ As the benefit will be paid to a tax dependant the table has ignored the tax components of the super death benefit.
The results suggest that through the deductibility of super contributions, Trevor can purchase an additional $263,300 in life insurance within his super and be cashflow neutral between these options.
As the death benefit will be tax free to the spouse, they will receive $263,300 more in death benefits for no extra cost.
Holding life insurance in super for the benefit of a non-tax dependant such as an adult child may also be beneficial. However, a super lump sum death benefit paid to an adult child may be taxable and death benefit pensions are not generally available.
Caution - creation of an untaxed amount on death benefit lump sums
A death benefit lump sum, including insurance proceeds where the super fund has claimed a deduction on insurance premiums, may contain an untaxed element. Death benefit lump sums containing an untaxed element are still tax-free to a tax dependant such as a spouse but may adversely affect a non-tax dependent beneficiary such as an adult child. This untaxed element is calculated according to the formula prescribed in s307.290 of ITAA 1997 and applies to the entire super death benefit, not just the insurance proceeds.
Please see TechConnect's Strategy Guide 'Superannuation death benefits' for more information.
Scenario 2 (a) - Holding life insurance for the benefit of an adult child (non-tax dependant)
Let us assume Trevor wishes to leave a lump sum to an adult child (non-tax dependant). Trevor will again have a choice between purchasing $500,000 of personally held life insurance or $763,300 of insurance in super, funded with personal deductible super contributions.
In scenario 1 proceeds were tax free. In this scenario they are not and we need to consider both the untaxed and taxable elements of the death benefit.
If we assume Trevor is age 50 when he takes out the policy within super and passes away one year later, a substantial untaxed element ($712,300) will be created on the payment of the death benefit lump sum.
The formula (s307.290 of ITAA 1997) reduces the untaxed element as the number of days to retirement declines, relative to service days. An earlier eligible start date is preferable in the context of reducing the untaxed element on a death benefit payment.
After death benefits tax, Trevor's adult child beneficiary will receive a net death benefit lump sum of approximately $526,700. This is $26,700 more than what they would receive had $500,000 of life insurance been held outside of super.
In comparison had Trevor funded policy premiums inside of super with NCCs, the after-tax cost and the premiums would be $1,250 and he would be limited to $500,000 of life insurance in super. Whilst Trevor may not claim a deduction on the NCCs, the super fund will still likely claim a deduction on insurance premiums meaning an untaxed element will arise. In this scenario the net death benefit lump sum available to a non-tax dependent is only $345,000 as illustrated in the table below.
^ Assumes Trevor's DOB is 01/09/1971 (age 50), Date of death 01/09/2022, ESD is 01/09/2021, eligible service start date was 1 year prior to date of death, retirement at age 65 and super fund claims a deduction on premiums. Death benefit paid directly to non-tax dependant and includes 2% Medicare levy.
The results suggest that the best outcome in this scenario would be for Trevor to hold life insurance through super and use concessional contributions to fund the premiums (assuming the life insurance is grossed up to equalise the after-tax cost of premiums).
In this instance, funding insurance through super with non-concessional contributions would lead to the least beneficial result as the super death benefit will be taxable to an adult child beneficiary. This might have been a consideration had Trevor already used up his concessional cap.
Scenario 2 (b) - Holding life insurance for the benefit of an adult child (non-tax dependant)
Trevor may instead decide to acquire his life insurance in an existing super fund. An existing fund may have an earlier service start period, and all else equal, may help reduce the untaxed element. On the other hand, the fund will have an existing balance that would have been free of an untaxed element had it been paid out as a death benefit without life insurance.
The comparison table below assumes Trevor already has $500,000 in accumulation (all taxable-taxed element) in an existing fund commenced 20 years ago with an eligible service start period of 01 September 2001. It also assumes he acquires $763,300 in life insurance bringing the total gross super death benefit to $1,263,300.
In this case Trevor's net death benefit is maximised by acquiring the life insurance in an existing super fund (Fund A) with an earlier service period rather than creating a new separate fund (Fund B) to hold the life insurance.
Advisers have many moving parts to consider before recommending that life insurance be acquired through super. These include deductibility of premiums, cashflow, available concessional contributions cap space and whether the intended beneficiary is likely to be a tax dependent.
Advisers can use the TechConnect Death benefit super lump sum calculator to help estimate the tax consequences of paying a death benefit to a non-tax dependant. This can assist to determine the level of insurance necessary as well as strategies mentioned in this article such as reducing tax impacts by paying a death benefit to an estate, acquiring life insurance in a new or old super fund and any other factors relevant to the client's personal circumstances.
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.