By Liam Shorte 23 Jul 2015

Insurance primer: Life insurance (Part 2)

Should you take out life insurance inside or outside super? We explain how to decide.

Snapshot

  • Life insurance premiums are deductible in super, but not in your own name
  • Cheaper through super, if the beneficiaries are dependants
  • Case studies covering scenarios where beneficiaries are non-dependants

In Insurance primer: Life insurance (Part 1) we explained why you need life insurance and what to look for in good (and bad) policies. The next question to tackle is whether you should take out the cover through your super fund?

Inside or outside super?

A big difference between life insurance and income protection (IP) is that in your own name, life premiums aren’t tax deductible. Depending on your marginal tax rateYour marginal tax rate is the tax rate that applies to the last dollar of your income. Australia has a progressive tax system where the marginal tax rate applied to individuals increases as your taxable income decreases. Current individual tax rates can be found at the ATO website., to pay a dollar in premiums you’ll need to earn as much as $1.96 of pre-tax income.

Paying through your super can reduce this effect substantially, potentially saving you thousands of dollars over the life of your policy. Not only will paying through your super fund secure a deduction for the premiums, you can also pay concessional contributionsThe 'normal' contributions made to your super account. Concessional contributions include compulsory contributions made on your behalf by your employer, voluntary contributions made out of your salary package and cash contributions by self-employed people (who are entitled to a tax deduction for it). Concessional contributions are either made from 'pre-tax' income or are tax deductible. See the ATO website for more information. from your pre-tax income (or claim a deduction if you’re self-employed) to fund the premium.

If you’re already making the maximum concessional contributionThe 'normal' contributions made to your super account. Concessional contributions include compulsory contributions made on your behalf by your employer, voluntary contributions made out of your salary package and cash contributions by self-employed people (who are entitled to a tax deduction for it). Concessional contributions are either made from 'pre-tax' income or are tax deductible. See the ATO website for more information. (currently $30,000, or $35,000 for those aged 49 and over) you can make a non-concessional contributionVoluntary contributions made to your super account out of after-tax income (savings). Non-concessional contributions are not tax deductible and can't be salary packaged. See the ATO website for more information. instead. But, as this contribution isn’t made pre-tax from your salary (nor tax deductible) the effective cost is higher.

Table 1 shows the pre-tax cost of each dollar of life insurance premium, where the targeted beneficiary is a dependant (for instance, spouse or minor child) of the insured person for tax purposes. The status of the beneficiary (as a dependant) is important since it means the payout from the super fund is tax-free.

Super wins hands down on net cost. Whether funded with concessional or non-concessional contributionsVoluntary contributions made to your super account out of after-tax income (savings). Non-concessional contributions are not tax deductible and can't be salary packaged. See the ATO website for more information., it’s the cheaper way to pay once the tax effects are taken into account. Best of all, it doesn’t have the limitations that taking IP through super has (see Insurance primer: Income protection (Part 2)) since the trigger for the payment of a benefit (death) is also a ‘condition of release’ under the SIS ActThe Superannuation Industry (Supervision) Act 1993. It is the main piece of law governing the operation of superannuation funds (including SMSFs)..

Note: If the intended beneficiary is a spouse, minor or certain disabled child dependants, it might be better to receive the superannuation benefit in pension form (in other cases the benefit must be paid as a lump sum). In most cases, even where some tax is payable on the income, paying benefits as pension income streams can prove to be more tax efficient in the long term. That’s because the tax on the pension often isn’t as costly as the benefit of the child or spouse effectively having a (tax free) pension-mode super account.

That’s the situation when benefits are being paid to tax dependants. But what if they’re not?

Benefits paid to non-dependants

Where the purpose of the insurance is to provide a lump sum death benefit to a non-dependant (for instance, an adult family member or business partner), the best strategy depends on the circumstances.

The key difference here is that a non-dependant doesn’t receive the super fund payout tax-free, so the insurance policy amount needs to be ‘grossed-up’ for any tax that will be payable. The amount of tax is a function of the components of the death benefit and the marginal tax rateYour marginal tax rate is the tax rate that applies to the last dollar of your income. Australia has a progressive tax system where the marginal tax rate applied to individuals increases as your taxable income decreases. Current individual tax rates can be found at the ATO website. of the recipient (and there are online calculators to help you out).

A death benefit consists of two main components – tax-free and taxable – with the taxable component further broken up into ‘taxed’ and ‘untaxed’ elements. No tax is payable on the tax-free component and a different rate is applied to each element of the taxable component (see Table 2).

The worst-case scenario (from a tax bill perspective) is a death benefit that consists entirely (or largely) of a taxable component that is ‘untaxed’. This is likely to be the case where the super account is small compared to the life insurance payout and the member is a long way off retirement (see Table 3 for the formula for calculating the components of a life payout).

In this case, if the recipient is on one of the higher marginal tax rates (32.5 per cent and above), the death benefit will be taxed at 17 per cent on the taxed element and 32 per cent on the untaxed element. So you need a policy that will cover not only the required cash payment to the recipient, but also the tax that’s payable (see Case Study A attached).

As a result, taking out a life policy through super will typically only be cost-effective if the premiums are funded by concessional contributionsThe 'normal' contributions made to your super account. Concessional contributions include compulsory contributions made on your behalf by your employer, voluntary contributions made out of your salary package and cash contributions by self-employed people (who are entitled to a tax deduction for it). Concessional contributions are either made from 'pre-tax' income or are tax deductible. See the ATO website for more information. (making them a pre-tax cost to the member). If they’re not, it’s cheaper (after-tax) for the member to take out the policy directly.

Even where the existing super account has a high tax-free component (see Case Study B), the resulting lower tax bill doesn’t change the outcome. Again, taking the policy out through super is only cost-effective if the premium is being funded with concessional contributionsThe 'normal' contributions made to your super account. Concessional contributions include compulsory contributions made on your behalf by your employer, voluntary contributions made out of your salary package and cash contributions by self-employed people (who are entitled to a tax deduction for it). Concessional contributions are either made from 'pre-tax' income or are tax deductible. See the ATO website for more information..

Where it gets really tricky is where the beneficiaries are a mix of dependants and non-dependants, or where some are on low marginal tax rates (or don’t earn any income). Another difficult situation is where future circumstances may change.

Arriving at a reliable rule of thumb is difficult when dealing with non-dependants. You simply need to do the calculations for the circumstances and make the best assumptions you can about how the future may play out.

In all cases, we strongly recommend seeking personal advice if you’re unsure about doing the calculations yourself.

Should you take out your policy through a separate super account?

An additional question that can arise with non-dependants is whether you are better off taking out an insurance policy through a second super account (assuming you’re able to), especially if it's been in existence for some time. The reason for this is that receiving a life insurance payout into an existing super account can effectively change the current tax-free/taxable mix.

Whether this is worthwhile depends on the facts of the situation, including the eligible service period of each account. In some cases it will be better to take out the policy in your main super account, in other cases taking it through a separate account can reduce the potential tax bill on the death benefit (and the grossed up level of insurance cover you need).

Need help?

Life insurance in super is a complicated topic and working out the best approach can be tricky. If you have questions, or need technical assistance, let us know via our Q&A function. But remember we can only provide general advice, not personal advice, in this format.

We strongly recommend seeking personal advice if you are unsure how to do the analysis, either via our personal advice service or from your own financial adviser.

 

Liam Shorte is a principal of Verante Financial Planning Pty Ltd (www.verante.com.au), a corporate authorised representative of Magnitude Group Pty Ltd (AFSL 221557). This article is a general information article and to the extent it contains any financial advice it is general advice only. We recommend seeking personal advice on your own circumstances.

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