How to minimise or allow for tax if your Total & Permanent Disablement (TPD) insurance policy is owned by your superannuation fund/account?
Taxation of TPD policies owned by Superannuation
Many people hold their TPD insurance covers in their superannuation account and don’t realise that a claim payment may be taxed if it is paid to them from super. Usually, TPD cover is held so that if total & permanent disablement occurs, a lump sum could be used to repay debt or fund living expenses and medical needs, therefore taking the tax liability into account is important when calculating the required sum insured.
How it works (as at the 2021FY)?
When a TPD payment is made from superannuation, there is a tax-free disability segment called the ‘Super Disability Benefit’ which is not subject to tax.
The calculation of this tax-free component depends on the time remaining between when the insured becomes disabled and their intended retirement (assumed to be age 65). The remainder will be allocated to the taxable component and taxed at normal super withdrawal rates.
- If a person suffers a TPD event prior to their preservation age (depending on their year of birth), the taxable portion of the benefit will be taxed at 22% (including 2% Medicare Levy) if drawn as a lump sum.
- If a person suffers a TPD event above their preservation age but under 59, the tax-free disability segment plus the first $215,000 of the taxable component will be tax free and the remaining portion will be taxed at 17% (including 2% Medicare Levy).
- For those over 60, the benefit will be paid completely tax free.
The Super Disability Benefit is calculated as follows:
A x B
C
where: A = the amount of the benefit
B = number of days from date of termination to ‘last retirement date’
C = total number of days from start of eligible service period to ‘last retirement date’
Example
John’s Date of Birth is 1 January 1970. His Earliest Service Date is 1 January 1991 (age 21) and his normal retirement date is 1 January 2035 (age 65). John has TPD insurance owned by his Superannuation Fund of $1,000,000.
John suffered an injury and was deemed totally and permanently disabled on 30 June 2015.
He is 45 years old. Since John was born after 1 July 1964, his preservation age is 60.
If John elects to receive a TPD benefit as a lump sum, the tax-free component will be:
TPD Sum Insured x number of days from date of termination to last retirement date
total number of days from start of eligible service period to last retirement date
$1,000,000 x 7,125 days
16,071 days
= $443,345
John will receive $443,345 of his TPD benefit completely tax free.
However, tax is payable at 22% on the remaining benefit of $556,655 which equates to $122,464.
The total net benefit payable to John would be reduced to $877,536. If he expected or needed to receive $1,000,000 then a problem exists.
For the purpose of this example, calculations have been done in whole years of 365 days and no leap years have been taken into account.
There are three main ways of dealing with this problem:
- Increase the sum insured by the amount of tax payable, and in turn the premium proportionately.
OR
- Hold the TPD cover in a new superannuation fund account without rolling over existing superannuation to it, so that the new policy start date becomes the Earliest Service Date for tax calculation purposes (most insurance companies have a non-investment superannuation facility that can be used for this). This way you can hold the TPD in super, but reduce the tax on the payment of a claim receipt out of super.
Note, there are other options that include taking the benefit all or partially as a pension, but there are still tax implications involved if you are under age 60 and therefore the net amount received may still be unexpectantly insufficient.
OR
- Alternatively, holding the TPD cover outside of super (personally) also eliminates the taxation problem in the event of a claim. However, personal cashflow, as opposed to cash within superannuation, or cashflow from superannuation contributions then needs to be used to fund the premiums.
SUMMARY
When you calculate the amount of TPD insurance cover you need, it is important to be aware of the tax that may apply when the cover is owned within a super account/fund and either allow for it, or structure the ownership so it can be minimised.
This information is of a general nature only and neither represents nor is intended to be specific advice on any particular matter. We strongly suggest that you seek professional financial advice before action. The information in this document reflects our understanding of existing legislation, proposed legislation, rulings etc as at the date of issue, but as with most areas of super, will almost certainly be subject to change.