Strategy paper - impact of the super reforms on insurance advice
In this paper, we consider the impact of the superannuation reforms commencing 1 July 2017 on insurance advice. The measures will mean insurance in superannuation will be even more attractive for many individuals; and less so for others.
Objective of superannuation
While the primary objective of super is quite narrowly focused on supplementing or substituting the age pension, the subsidiary objectives make no mention of insurance. This has been seen by the industry as a significant omission given that 70% of life insurance policies are held in super (Rice Warner) and it is mandatory for SMSF trustees to consider insurance as part of the SMSF’s investment strategy. However, the draft super regulations recognise the role that insurance in superannuation plays: “A range of other benefits may also be provided through superannuation, for example advice or insurance. However, the core purpose of superannuation is to provide income in retirement”.
Insurance is designed to provide the shortfall in retirement capital in the event of death or disability. Therefore, it makes logical sense to combine it with the vehicle designed to accumulate retirement wealth, superannuation.
Consequently, the provision of insurance in super aligns with the primary and subsidiary objectives of super.
Low income earners
For low income earners, the real advantage of insurance in super is that they can have insurance that may be unaffordable outside superannuation due to cash flow limitations.
Couples with low income/non-working spouse
More couples can attract a tax offset from 1 July 2017 by structuring insurance in super for a low income/non-working spouse and funding the premiums via spouse contributions.
When a person contributes to super on behalf of their spouse, a tax offset of $540 is available where:
- the spouse earns less than $37,000 pa (currently $10,800), and
- contributions of $3,000 or more are made.
There is also an option to fund insurance premiums using:
- Government co-contributions by making non-concessional contributions to super (income must be below $51,021)
- concessional contributions - the low income super tax offset (LISTO) means no contributions tax is payable (income must be below $37,000).
Note: Total super balance must be less than the transfer balance cap (TBC) ($1.6 million in 2017/18) to be eligible:
- to make NCCs
- the spouse contribution tax-offset, and
- Government co-contributions.
For younger clients in this category focussed on paying down mortgage debt and maximising cashflow for general living expenses, insurance is about protecting against life’s risk without impacting disposable income.
There are two main reasons why life insurance through super makes sense for these clients:
- Tax – the ability to fund insurance premiums through super with before-tax income can reduce the after-tax cost.
- Cash flow – the ability to use super to fund life insurance premiums preserves disposable income.
The super reforms do not change these advantages of insuring in super for middle income earners. In fact, two new measures enhance the ability of middle income earners to fund insurance in super:
- the ability to claim a tax deduction on personal contributions (up to the CC cap) means more individuals (including contractors and partially self-employed) can fund insurance in super tax effectively, and
- the ability to carry forward unused concessional contributions (from 1 July 2018) means individuals can potentially fund larger insurance premiums in super (subject to total super balance of $500,000).
Individuals who are currently funding insurance in super who are close to, or have used, their CC cap will need to review their funding arrangements.
The reduction in the concessional contributions (CC) cap will mean:
- the ability to fund insurance in super is restricted, and
- the ability to replenish superannuation savings depleted by insurance premiums is diminished.
With the ability to save less in super, the diversion of super to fund insurance premiums will mean lower retirement savings. Younger clients with lower super balances and good cash flow could consider holding insurance outside super so super contributions are allocated entirely towards retirement savings.
Note: moving existing insurance in super outside super may mean:
- further health evidence is required
- the same terms/definitions may not be available.
The cost of funding insurance in super with concessional contributions will increase for those earning in excess of $250,000. While your middle income clients may not think this impacts them, taxable capital gains or employment termination payments can push their income to this level.
High income earners
Those individuals most affected by the reduction in the CC cap are those with average income of $200,000 and average super balances of $760,000 ie around 3% of super fund members.*
Individuals earning $206,480 pa (salary beyond which SG is not required in 2016/17) or above will attract SG of $19,616, leaving only $5,384 of available CCs before the cap is reached.
High income earners may not have cash flow limitations but they can make insurance premiums more affordable by using salary sacrifice contributions to effectively pay for the premiums in pre-tax dollars.
The cost of funding insurance in super with concessional contributions will increase for those earning in excess of $250,000. However, funding insurance premiums through super with before-tax income can reduce the after-tax cost for high income earners by 47%^ (if income is below $250k) or 32%^ (if income is $250k or above) so this remains a tax-effective strategy.
Note: those earning $250,000 and above may wish to consider holding income protection (IP) insurance outside super as they incur a 15% surcharge in super compared with holding it outside. High income earners without cash flow limitations may consider holding all insurances outside super.
Those individuals currently contributing up to the $30,000 or $35,000 CC cap in 2016/17 can consider the following options for the excess $5,000/$10,000:
- make NCCs (subject to total super balance being less than the general TBC of $1.6m in 2017/18)
- invest outside super
- if they have a spouse, spouse can make CCs if available unused cap or utilise the options under “couples with low income/non-working spouse” outlined previously.
* Federal Government Budget 2016 fact sheet (the median Australian worker currently makes CCs of around $4,500 per year).
^ most super funds pass on the deduction claimed on the payment of insurance premiums as an offset on 15% contributions tax on CCs; temporary Budget Repair levy removed from 1 July 2017
Clients on IP claim
The removal of the 10% test (requires less than 10% of total income from employment sources) to claim a tax deduction for super contributions means more individuals will be eligible for tax deductions on after-tax money contributed to fund insurance.
This removes a particular impediment to personal tax deductible super contributions by those on income protection claim. It has generally been the case that while IP claimants remain ‘on the books’ of the employer, the IP payments are treated as employment income, making the 10% test unlikely to be satisfied without significant non-employment income (eg investment income). If the 10% test is failed, generally the only other option to make pre-tax super contributions is via a salary sacrifice arrangement (which isn’t available to IP claimants).
The removal of the 10% test will mean these individuals can make tax deductible contributions to super.
Clients who are both salary sacrificing and have employer-funded group insurance will need to review their level of salary sacrifice to ensure the lower CC cap of $25,000 is not exceeded. Employer contributions to fund insurance premiums count in the CC cap.
The attraction of cheaper group insurance rates in super has traditionally been a benefit of holding insurance in super. Steep premium rises in recent years coupled with the lower CC cap may cause these clients to question the allocation of limited cap space to fund insurance premiums. Advisers may wish to review insurance arrangements for senior executives in corporate and consider whether to move insurance, especially IP, outside super.
Master trust clients
Some recipients of death benefits from Master trust owned insurance-only accounts have traditionally been restricted to lump sums. The ability to roll over death benefits to another super fund to commence a death benefit income stream (eligible beneficiaries only) will give these clients’ beneficiaries more choice.
There are generally two insurance strategies to manage liquidity and prevent the forced sale of a property in the event of the death of an SMSF member where the fund has a limited recourse borrowing arrangement (LRBA):
- payment of insurance benefits as a pension to spouse
- member(s) hold insurance outside super and contribute the proceeds as NCCs.
The first strategy may be impacted by the TBC (see ‘estate planning’) and the second strategy is impacted by the reduction in the annual and bring forward NCC caps.
A strategy for SMSF clients to address liquidity is to hold insurance outside super (either self, cross or trust-owned) and make NCCs with the insurance proceeds to pay down the debt. The strategy will be restricted by the lower NCC contribution caps going forward.
With the removal of the anti-detriment, SMSFs that are holding insurance policies to fund the payment will need to review these.
Allocations from reserves count as concessional contributions and will be impacted by the reduced CC cap.
Small business owners who have partial employment income
Small business owners engaged in some form of SG qualifying employment activity (eg as a director of a private company, consultant), may prohibit a personal tax deductible super contribution from being made, thereby preventing them from funding insurance in super tax-effectively.
Similarly, individuals who undertake both self-employment and PAYG-employment during a financial year (eg a short-term contract/project) may face the same barrier.
The removal of the 10% rule means more small business owners can fund insurance in super tax effectively.
Existing and future estate planning arrangements should be reviewed for clients with large amounts in super and/or large sums insured.
Transfer balance cap and insurance proceeds
From 1 July 2017, a transfer balance cap (TBC) ($1.6 million in 2017/18) limits the total amount of superannuation that can be transferred into the pension phase where investment earnings (including capital gains) are tax-free.
An individual’s transfer balance account (TBA) will track the net amount transferred into pensions - transfers to and from pension phase will give rise to corresponding credits (increases) and debits (decreases).
Life insurance proceeds - spouse
Death benefit pensions sourced from accumulated super and/or life insurance proceeds (whether in the deceased’s accumulation or pension account) will count as a credit in a reversionary spouse’s TBA. The credit arises up to 12 months after the date of death in the case of an automatic reversionary pension beneficiary (where the beneficiary is nominated at commencement).
If the reversionary pension (or the combined value of a reversionary pension and an existing pension) exceeds the recipient’s TBC, the excess must be removed from super.
Life insurance proceeds - child
The amount which can be paid to a child as a pension, without exceeding the child’s transfer balance cap (TBC) depends on whether the deceased parent had already commenced a pension ie had a TBC.
The general rules for child pensions commenced from 1 July 2017 are:
- deceased parent in accumulation phase – child pension(s) can be paid up to general TBC ($1.6 million in 2017/18), excess must be paid as death benefit lump sum. Insurance proceeds can be paid as a death benefit pension up to child’s proportionate share of the general TBC.
- deceased parent in pension phase – child pension(s) can be paid from their proportionate share of the pension account. If any amount in accumulation this must be paid as a death benefit lump sum. For example, if parent has $1 million in super ($750k in pension a/c and $250k in accumulation a/c) a child pension of $750k can be paid. A child pension cannot be paid from the $250k accumulation a/c - insurance proceeds are deemed to arise from the accumulation account, therefore, a child pension cannot be paid with the insurance proceeds.
- spouses and other beneficiaries will need to consider the effect on their transfer balance cap of taking a death benefit pension
- whether to have an auto reversion to spouse in place rather than a binding nomination [with auto reversion - 12-month window before credit arises in TBA, insurance proceeds (where premiums paid from pension account) take on the same proportion of the underlying taxable and tax-free components]
- whether to nominate children to receive child pensions or have benefit paid to testamentary trusts via the estate
- whether to commence a pension while alive to maximise the amount of child pensions
- whether to retain super money solely in accumulation (if more than one minor child) to ensure each child can receive a death benefit pension up to the general TBC
- recontribution strategies (to reduce tax on death benefits to non-tax dependants) will be restricted by the reduced NCC caps.
TPD insurance proceeds
TPD insurance proceeds (where premiums are funded from a pension account) may not count as a credit in the recipient’s TBA. Insurance proceeds are currently treated in the same way as investment returns, which are ignored for pension transfer cap purposes. In contrast, where TPD insurance proceeds (premiums are funded from an accumulation account) are subsequently used to commence a disability super pension they will count in the recipient’s TBA. Grossed-up TPD sums insured used to commence a pension will have an even greater impact on the recipient’s TBC.
Insurance strategies in action
Strategy: life insurance funded by personal deductible contributions
Tim (age 45) earns $100,000 pa plus SG ($10,000) and has surplus income of $15,000 at the end of the financial year. His adviser has recommended $2 million of life and TPD cover.
He could hold insurance outside super. Alternatively, he could contribute the $15,000 to super to fund insurance in super.
From 1 July 2017, Tim could make a CC of $15,000. He can claim the $15,000 as a tax deduction and receive a refund of $5,850 which could then be contributed as an NCC. Therefore, Tim has contributed a total net contribution of $30,850 ($15,000 personal deductible, $10,000 SG and $5,850 NCC), some of which could be used to fund his insurance premiums tax-effectively.
He can also now afford level rates (vs stepped premiums) which will enable him to afford to hold his cover for the long term.
Strategy: reduce tax by funding spouse’s insurance
Gordon (45) who is married to Scarlett (34). Gordon works full time and earns $120,000 ($85,568 net) per annum whilst Scarlett works part-time in a day care centre earning $37,000 per annum.
After speaking with his adviser, Gordon learns that he can make a $3,000 non-concessional contribution to his Scarlett’s super account and receive a tax offset of $540.
|Less spouse contribution||$3,000|
|Net income after spouse contribution||$83,108|
The $3,000 can be used by Scarlett to fund her insurance premiums in super.
Strategy: use TTR pension to fund insurance outside super
David (age 61) is divorced and has two adult children from a previous marriage. He is currently in a de facto relationship with Veronica. David is still working part-time, has sufficient super savings but a tight cash flow. He wishes to provide for Veronica and his children equally in the event of his death but is aware that his children will face tax of up to 32% on a superannuation death benefit.
David speaks to his financial adviser who suggests that David consider holding his life cover outside super and fund the premiums using tax-free income from a TTR pension (commenced solely to boost his net income).
Note re TTRs from 1 July 2017:
- the net personal tax saving of a TTR is significantly reduced for those under age 60 (however, the strategy is still tax effective where the account balance comprises a large tax-free component)
- significant tax savings are still available for individuals age 60 or over (as TTR pension payments are tax-free)
- TTR pensions are still attractive for individuals reducing work hours and using a TTR to supplement their income.
Strategy: deliberately breach CC cap to fund insurance premiums
It is possible to intentionally exceed the CC cap for the purposes of funding life insurance premiums inside superannuation and still achieve a tax effective outcome for certain individuals. The reason for this is that the excess CC charge is lower than the premium rebate passed from the super fund trustee to the individual’s super account.
This strategy can be employed for those with MTRs of 34.5%, 39% and 47% (not earning more than $250,000 per annum) if not close to their NCC cap. A breach of both the CC and NCC caps may erode any tax advantages achieved through this strategy. Excess CCs left in the fund count in the NCC cap, while amounts withdrawn do not.
For those advisers who look after corporate funds there may be opportunities to review senior executives and restructure their insurances, including moving any funded IP outside of superannuation to allow for more concessional contributions to remain in superannuation.
For high income earners who wish to maintain their lifestyles in retirement it may well be worth restructuring any life insurances held in superannuation to be held outside. Whilst there will be a loss of tax deductibility for insurance premiums, the potential taxation of the proceeds is also removed. Not only this, but their long term goal to maintain lifestyle in retirement will be better served.
Low to middle-income earners have the most to gain from these superannuation reforms, especially with the introduction of deductible superannuation contributions. This particular measure can be used to encourage greater savings for retirement or to make “level” premiums for lump sum cover (life and TPD any occupation) more palatable.
The super reforms represent a great opportunity to get in touch with clients and review their insurance strategies to ensure they understand their options and the implications.
Should you require more information contact the Technical Strategy Team on 1300 361 522.