Are Life Insurance Premiums Deductible?

Where the life insurance is provided through a superannuation fund, contributions made to fund insurance premiums are tax deductible for self employed persons and substantially self-employed persons and employers.

However where life insurance is held outside of the superannuation environment, the premiums are generally not tax deductible.

For insurance through a superannuation fund, the annual deductible contributions to the superannuation funds are subject to age limits. These limits are indexed annually to movements in Average Weekly Ordinary Time Earnings. For 2004/2005 the limits are:

These limits apply to employers making deductible contributions. They also apply to self-employed persons and substantially self-employed persons.

Included in these overall limits are insurance premiums. This means that no additional deductible contributions can be made for the funding of insurance premiums. Insurance premiums can, however, be funded by undeducted contributions.

For further information on deductible contributions see "under what conditions can an employer claim a deduction for contributions made on behalf of their employees?" and "what is the definition of substantially self employed?"

The insurance premium paid by the superannuation fund can be claimed by the fund as a deduction to reduce the 15% tax on contributions and earnings.

Ref: ITAA 1936, Section 279

Is it essential that contributions be paid to fund life insurance premiums?

It is not essential that contributions be paid to a superannuation fund in order to fund payment of insurance premiums. Premiums can be paid from the accumulated benefits in a superannuation account.

Is there a limit to the level of life insurance cover available through a superannuation fund?

There is no limit on the level of death or total and permanent insurance (TPD) cover which can be provided through a superannuation fund. There are however limits on the amount of lump sum benefits which can be paid at concessionally taxed rates. The RBL system applies a concessionally taxed limit of the member's pension RBL on the level of lump sum death benefits.

For most people the concessionally taxed limit is the pension RBL which is $1,238,440 for the 2004/2005 financial year. For those with a transitional pension RBL, the limit will be higher.

Should you insure through superannuation?

When deciding whether to fund life insurance through a superannuation fund, there are a number of factors that need to be considered including:

a) tax consequences;
b) reasonable benefit limits (RBL's); and
c) estate planning issues.

Taxation and insurance premiums

Funding life insurance through a complying superannuation fund has the following advantages:

• the insured's assessable income may be reduced by the cost of the insurance premium where the premiums are funded through a salary sacrifice arrangement or as a personal deductible superannuation contribution (eg. self employed);
• the cost of the insurance premium is reduced, as it is paid with before-tax dollars. For example, an insurance premium of $500 pa outside of superannuation would require $970 of pre-tax money (assuming a marginal tax rate of 48.5%). Whereas if the policy was within superannuation, contributions such as employer contributions are not subject to marginal tax rates so the cost of the premium would be $500. (Note that the superannuation contribution may be subject to surcharge which reduces tax effectiveness);
• the superannuation fund will generally not be subject to contributions tax on the superannuation contribution used to fund the premium as the tax payable is offset by the fund receiving a tax deduction for the premium.

Taxation and insurance proceeds

The next point to consider is the taxation of the insurance proceeds. As the insurance policy is within the superannuation fund, the proceeds will form part of the client's superannuation account. How these proceeds are taxed depends on the following factors:

Where the insurance proceeds are paid as a result of death, the taxation will depend on whether the death benefit is paid to a dependant or non-dependant. A dependant for tax purposes includes a spouse, child under 18 or financial dependant. Where a lump sum payment is made to dependants the payment is tax free up to the deceased's pension RBL. When paid to a non-dependant it is taxable at a maximum of 16.5%. In both cases any excess above the deceased's pension RBL is taxed at 48.5%. Generally, where a tax deduction was claimed by the super fund in respect of the premiums that funded the death benefit, a portion of the benefit would be an untaxed component. A lump sum payment containing an untaxed component when paid to a non-dependant is liable to a maximum tax of 31.5%. When paid to a dependant it is tax exempt provided it is non-excessive. As a result it can be beneficial to limit the amount of lump sum death benefits paid to the deceased's pension RBL. In addition, it can also be beneficial to avoid paying a lump sum to a non-dependant that consists of an untaxed component. However where the trustee of the superannuation fund is able to pay a pension upon the death of the member, a combination of lump sums and pensions can be utilised to pay an amount exceeding the deceased's pension RBL tax effectively.

A pension paid as a result of death is not assessed against the deceased's pension RBL. Rather where the dependant is over 18 it is assessed against the dependant's RBL. Where the dependant is under 18 it is not assessed against anyone's RBL! Therefore it is possible for a dependant to receive an amount exceeding the pension RBL tax effectively by utilising a combination of a lump sum and a pension. This strategy is particularly effective where there is more than one dependant.

Case Study

Mr and Mrs Jones are aged 50 and 48 respectively. They have a financially independent daughter, Lucy (25 years old) and a son, Mark (16 years old). Mr Jones has accumulated superannuation benefits of $400,000 and life insurance through an employer-sponsored super fund of $1.5M. He is not eligible for a transitional RBL. Mrs Jones has a minimal amount of super. Mr Jones was involved in a fatal accident. Let's assume the insurance premiums were tax deductible to the super fund, thus creating an untaxed component of say, $300,000 with the balance being all Pre/Post (taxed). How should the death benefit payment be structured?

1. Pay Mrs Jones a lump sum of $1,058,742
As Mrs Jones is a dependant for tax purposes she can receive up to her deceased husband's pension RBL of $1,058,742 (2001/02) tax-free. This sum can be directed towards paying off the family's non-tax deductible debts such as the home mortgage or re-contributed into superannuation as an undeducted contribution to take advantage of the concessional tax treatment (provided she meets the contribution rules). Please note that it is not possible to rollover these funds to superannuation.

2. Pay Mrs Jones an Allocated Pension of $436,732
The allocated pension will be assessed against Mrs Jones' discounted lump sum RBL. As she is less than 55 years of age, her discounted lump sum RBL is $436,732 (ie the standard lump sum RBL of $529,373 reduced by 2.5% for every year she is under the age of 55). The allocated pension will be fully rebatable as it does not exceed her lump sum RBL.

3. Pay Mark an allocated pension with the remainder of $404,526
This allocated pension is not counted for RBL purposes, as it is payable to a dependant under 18 upon a member's death. It is treated as fully rebatable, entitling Mark to a 15% tax rebate and is taxed at adult marginal tax rates. It will not be counted towards Mark's RBL unless Mark commutes the pension outside the prescribed period at a later date.

4. What about Lucy?
As Lucy is over 18 and not a financial dependant she does not qualify as a dependant for tax purposes. If a lump sum was paid to Lucy it would be assessed against her deceased father's pension RBL. Given that her mother has exhausted her deceased father's pension RBL, the lump sum payment to Lucy would be all excessive and taxable at 48.5%!However, if Lucy's mother were to split the lump sum payment with Lucy, the excessive tax penalty can be avoided. Although the lump sum payment to Lucy is not excessive, she will still be liable to tax at a reduced rate given her non-dependency tax status. If the lump sum contains the untaxed component of $300,000, Lucy is liable to a maximum tax of $94,500 (ie 31.5% x $300,000) on that portion. The balance of the lump sum payment is subject to a maximum of 16.5%.If Lucy were paid an allocated pension, she would be assessed against her discounted lump sum RBL of $132,343. If the purchase price exceeded $132,343, an excessive component would arise and she would not receive the full 15% rebate. Therefore, as a result of Lucy's non-dependency tax status, it may be more tax effective for Lucy to receive part of the lump sum paid to Mrs Jones as it was paid tax-free. This amount could then be invested for Lucy according to her investment needs.

Point to note - If a binding nomination is completed, the trustee of the superannuation fund is obligated to pay the nominated dependants in the specified proportion. However, the trustee has the discretion to pay the death benefit as a lump sum and/or a pension. The trustee need only be bound on who the death benefit is to be paid, not the form in which it is to be paid.

Conclusions

When determining the amount of life cover to insure through superannuation it is important to consider the number of dependants, and whether it is possible to use a combination of lump sums and pensions to pay out the death benefits. By using a combination of payments, it is possible to pay an amount exceeding the deceased's pension RBL tax effectively.

Provided compliments of Super Outsource Pty Ltd (SMSF Specialists)

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