Income Protection Insurance

This month’s Wealth Pipeline discusses the main advantages and disadvantages of personally holding income protection (IP) insurance compared to holding IP inside a superannuation fund.  

Income Protection in General

Many believe that income protection premiums are fully tax deductible.  However, this is not always the case.  As income protection policies are designed to replace income at the time of a claim, the Australian Tax Office (ATO) allows a tax deduction on the premiums paid.  These deductions are dependent on claims being treated as income and not capital.  As a result, if there is a component of the IP premium that goes towards a death or physical injury benefit, then that part of the premium is not an allowable deduction.  IP premiums inside superannuation are only tax deductible to the extent that the policy terms satisfies the SIS Act’s ‘temporary incapacity’ definition. 

Advantages

• If an individual’s marginal tax rate (MTR) is higher than the superannuation tax rate of 15% then holding the policy personally will reduce the after tax cost of the cover.  For example, if an individual’s MTR is 46.5% and their IP premiums are $2,000 and personally held then the after tax cost would be $1,070.  If held inside the superannuation environment the after tax cost would be $1,700.  Hence, a $630 after tax saving is obtained by personally holding the cover.
• Generally, IP policies held outside of superannuation have more policy features than those held inside of superannuation.  Examples include the choice of level or stepped premiums, agreed value and various waiting and benefit periods.
• Holding IP insurance outside of super means that the life insured will only need to meet the requirements of the insurance provider.  As a result, access to claims are generally easier to obtain for those who hold income protection insurance outside of super.

Disadvantages

• For clients who would prefer not to use their personal funds to service their insurance, IP insurance within superannuation is the better option.  By choosing to hold your income protection (or any life insurance) within superannuation, premiums are paid with your member balance and not from personal funds. 
• If your marginal tax rate is lower than the superannuation tax rate of 15% then holding the policy inside superannuation should reduce the after tax cost of the cover.  This will be the case for individuals earnings less than $18,000 per annum.
• When insurance is held within superannuation the premiums are paid by the trustee of the super fund.  Therefore, tax deductions are claimed by the trustee and not the member (life insured).  As a result, it is at the discretion of the trustee whether to pass on the tax deduction to the member (life insured).  There is no guarantee that the member (life insured) will benefit from lower premiums associated with the tax deductions.  
• Unless an individual has an SMSF they are restricted to use the insurance provider(s) of their superannuation fund.  The specific disadvantages of this can include:
  • There may be a requirement that the life insured discharge all of their sick leave before a claim will be paid.
  • Policy features such as level or stepped premiums, agreed value and various waiting and benefit periods may be limited or not available.
  • The possibility of pre medical exclusions associated with group cover.
  • Benefit payments inside of superannuation can only be paid from the fund to the member for the period of incapacity.  For example, if the life insured is disabled for two months but receives a ‘specific injuries benefit’ that covers 18 months of income, the member will only receive two months of income.   The remaining 16 months of income is retained by the fund.
  • Benefits payments from a superannuation fund are arguably limited to the income the member is earning at the time of claim.  This is particularly dangerous for agreed value policies where the policy holder’s current income is below the sum insured.  It is also dangerous for claims paid out over long benefit periods as the payments should not be increased for inflation.