For clients with insurance cover held inside superannuation, there are a number of factors to consider, including how premiums will be funded and the payment of benefits. In particular, where premiums are to be funded via a rollover from another fund, consideration should be given to the impact of the client’s service period on any benefits subsequently paid from the fund.
What is a client’s service period?
The service period start date for a client’s superannuation interest is typically the day they joined the relevant fund. However, the start date may be an earlier day where:
- benefits are rolled over from another fund with an earlier service period start date - the earlier start will be applied to the new fund
- a standard employer-sponsor contributes to the fund and employment commenced on an earlier date – the start date will be the first day of employment
Why is a client’s service period relevant?
A client’s service period start date is used in calculating tax on lump sum superannuation benefits payable on death or disablement.
It is an important consideration for clients with insurance cover held inside superannuation, as the service period of the fund holding the insurance can impact the amount of tax payable on any insured benefits paid from the fund.
Impact of service period on life insurance in superannuation
Where a lump sum death benefit is paid to a beneficiary who is not a dependant for tax purposes and the trustee of the fund has either claimed a deduction for life insurance premiums or for the future service portion of the benefit, the deceased’s service period is used to calculate the tax components of the benefit.
The taxable component of the death benefit will be split into elements taxed and untaxed in proportion to the deceased’s ‘actual’ and ‘future service’.
The element taxed represents the deceased’s ‘actual service’ period, which is calculated from the service period start date of their superannuation interest to their date of death.
The ‘element untaxed’ represents the deceased’s ‘future service’ period, which is calculated from their date of death until their expected retirement date (generally age 65).
Tip
Where a lump sum death benefit is paid to a non-dependent beneficiary for tax purposes, the ‘element untaxed’ is taxed at a higher rate than the ‘element taxed’ as shown in the table below.
| Beneficiary | Tax-free component | Taxable component | |
|---|---|---|---|
| Element taxed | Element untaxed | ||
| Dependant | Non-assessable non-exempt income | ||
| Non-dependant | Non-assessable non-exempt income | 15%* | 30%* |
* Plus Medicare levy (not payable if paid via the deceased’s estate)
* For non-dependent (tax definition) beneficiaries, the element taxed and element untaxed amounts are added to the taxpayer’s assessable income. The taxpayer receives a tax offset to ensure the effective tax rate does not exceed the maximum rate shown above.
There may be an advantage in ensuring as long a service period as possible applies in the fund holding the insurance to increase the ‘element taxed’ and lower the effective tax rate on the overall benefit.
However, holding life insurance in the same fund as a client’s accumulating benefits can have the effect of increasing the tax payable on those benefits, due to the inclusion of an ‘element untaxed’.
Example 1
Christine is 45 years old and has a son, Tom, who is a non-dependant for tax purposes. She has $400,000 life cover in an insurance-only fund (Fund A) that she would like to leave Tom in the event of her death. If Christine contributes to Fund A to meet the premiums, the insurance benefits paid from the fund would be virtually all taxable component (element untaxed), as there is minimal or no actual service in Fund A (assuming she passed away today).
Alternatively, if she rolls over benefits from another fund (Fund B) to meet the insurance premiums, the service period start date from Fund B would be applied to Fund A.
If Christine had a service period of 20 years with Fund B, this service period would be applied to Fund A. Any death benefit paid to Tom from Fund A would then be split 50:50 between taxable component (element taxed) and taxable component (element untaxed). As the element untaxed is reduced, the effective tax rate on the death benefit when it is paid to Tom is also reduced.
The table below illustrates this example.
| Fund A insurance-only (premiums paid by contributions) | Fund A insurance-only (premiums paid by rollover) | |
|---|---|---|
| Actual service period | Virtually nil | 20 years |
| Life insurance | $400,000 | $400,000 |
| Death benefit payable | $400,000 | $400,000 |
| Components | ||
| Taxable component (element taxed) - taxed at 15%* | Nil | $200,000 |
| Taxable component (element untaxed) - taxed at 30%* | $400,000 | $200,000 |
| Tax payable (if paid to non-dependant) | ($128,000) | ($98,000) |
| Net death benefit | $272,000 | $302,000 |
*Plus Medicare levy
Impact of service period on TPD insurance in superannuation
Where a lump sum superannuation benefit is paid as a result of a client’s permanent incapacity, an additional tax-free component, based on the client’s service period, may be included in the benefit payment.
The additional tax-free component represents the client’s ‘future service’, which is generally the period from the date the client stopped being capable of being gainfully employed until their last retirement day (generally their 65th birthday).
In the case where the client has no accumulated tax-free component, the remaining benefit will be taxable component. This represents the client’s ‘actual service’, which is calculated from the service period start date of their superannuation interest to the date of payment.
Trap
For total and permanent disablement (TPD) insurance inside superannuation, the application of an earlier start date can have the effect of increasing the tax on any lump sum disability superannuation benefit ultimately paid from the fund. This is because the earlier start will increase the ‘actual service’ period in the fund and reduce the additional tax-free component of the benefit that would have otherwise applied.
Example 2
Let’s return to our example of Christine. She also has $400,000 TPD cover in an insurance-only fund (Fund A). If Christine contributes to Fund A to meet the premiums, the insurance benefits paid from the fund would be virtually all tax-free, as there is minimal or no past service in Fund A (assuming she is incapacitated today).
Alternatively, if she rolls benefits from Fund B to meet the insurance premiums, Fund B’s 20-year service period would be applied to Fund A. As a result, any disability superannuation benefit paid from Fund A would be split 50:50 between tax-free component and taxable component, resulting in half the benefit being taxable.
The table below illustrates this example.
| Fund A insurance-only (premiums paid by contributions) | Fund A insurance-only (Premium paid by rollover) | |
|---|---|---|
| Actual service period | Virtually nil | 20 years |
| TPD insurance | $400,000 | $400,000 |
| Disability benefit payable | $400,000 | $400,000 |
| Components | ||
| Taxable component (element taxed) - taxed at 20%* | Nil | $200,000 |
| Tax-free component | $400,000 | $200,000 |
| Tax payable | Nill | ($44,000) |
| Net disability benefit | $400,000 | $356,000 |
*Plus Medicare levy
The service period conflict
As illustrated above, there is a conflict between the optimal service period for death benefits and the optimal service period for permanent incapacity benefits. However, to the extent that death benefits are paid as a lump sum directly from the fund to a dependant beneficiary, no tax will be payable on the benefit. In this case, service period will only be relevant for permanent incapacity benefits and there may be advantages in minimising the client’s service period in the fund that holds TPD insurance.
