Taxation of Life Insurance in Superannuation
All superannuation funds within Australia offer members Life Insurance in superannuation and it is common for people to hold some level of Life Insurance within their superannuation. In fact since 2008 it has been mandatory for employer sponsored superannuation funds to offer a minimum standard level of Life Insurance in superannuation of up to $50,000. There are however critical difference’s in regards to the taxation of life insurance claims in superannuation that need to be considered when determining if the right person will get paid the right amount on death.
Although the benefits will pay on the same event compared to owning life insurance outside of superannuation; the amount received by a beneficiary does not always get treated the same for taxation purposes. Without a working understanding of the different regimes, it can leave family members shouldering a short-fall.
Firstly, any life insurance policy that is self-owned (i.e. outside of superannuation) and for personal protection requirements can be paid to anyone without any taxation liabilities. In addition, a self-owned policy can basically nominate any person or entity unless restricted by the individual insurer.
But by owning life insurance in superannuation, the taxation regime becomes a little more complex. With any life policy owned and held under a superannuation fund (including a SMSF), the proceeds payable fall under the additional requirements imposed by the Superannuation Industry (Supervision) Act 1993 and the Income Tax Assessment Act 1997. The former limits who can be nominated and the latter determine the tax payable on proceeds.
A superannuation fund can only pay a benefit to a legal representative or a person who is financially dependent on the member. A legal representative includes, children (including step-children, ex-nuptial and adopted), spouses (including de-facto and same sex) and can include ex-spouses.
Although the scope of who can be paid is more limited under superannuation, the beneficiaries are also split again between two taxation regimes and would be classed as either;
- Financially Dependant (Taxation Dependant)
If a beneficiary is classed as financially dependent then life insurance proceeds paid from superannuation are paid tax-free. Some beneficiaries are automatically classed as ‘taxation dependants’ and these include current spouses and children under the age of 18.
If a person who is not a current spouse or minor child can establish that they have what is termed an ‘interdependency relationship’ under s302-200 (ITAA 1997) then they will too have proceeds paid without a taxation liability. This does include ex-spouses, other family members (e.g. brothers, parents) and adult children, however in order to have proceeds paid tax-free the relationship must be established and in some circumstances it can be somewhat difficult. In order to establish the relationship, the following must exist;
- they have a close personal relationship, and
- they live together, even if they are not related by family, and
- one or each of them provides the other with financial and domestic support and personal care.
If an ‘interdependency relationship’ cannot be established and as long as the beneficiary is eligible to receive benefits under superannuation legislation, then the beneficiary will be classed as a ‘non-dependant’ and will incur a taxation liability. This is most common with adult children.
To complicate matters further for members, although the rates of taxation are flat, the rates differ depending on the different components within the superannuation fund. A life insurance claim payout will be split into the different taxable components of the fund (tax free component and taxable component, further comprised by the taxed and untaxed elements) by the same percentage as the existing accumulated benefits.
Calculating the taxation liability can be somewhat difficult as the ‘taxed element of the taxable component’ is taxed at 16.5% (including Medicare Levy) and the ‘untaxed element of the taxable component’ is taxed at 31.5% (including Medicare Levy), furthermore the percentage of funds that makes up each component depends on when the member entered the fund and the time until the member would have retired.
Take this scenario as an example;
Andrew aged 50 suddenly dies of a heart attack on the 1st February 2012. Over his lifetime he has accumulated $300,000 in superannuation assets and was insured for $600,000. Andrew nominated his 22 year old son to receive his entire benefit who is no longer dependant. Andrews son is working part-time and lives with friends.
Although the gross amount of benefits left to Andrews son is $900,000, he would receive the following amount after accounting for taxation;
‘untaxed element of the taxable component’
$900,000 x (5,164 / 13,384) = $347,250
$347,250 x 31.5% = $109,383
‘taxed element of the taxable component’
$900,000 – $347,250 = $552,750
$552,750 x 16.5% = $91,203
Total taxation payable = $109,383 + $91,203 = $200,586
Net benefit payable = $900,000 – $200,586 = $699,414
*Andrew’s entire balance was comprised of a ‘taxable component.’ He was born 22nd March 1961, joined the fund on the 31st July 1989 and died on the 1st February 2012. The number of days from fund start date to notional retirement is 13,384 days and the number of days from death until national retirement is 5,164 days.
From the example above, Andrew’s son in this scenario would have incurred a taxation liability of $200,586 and would have received a net amount of $699,414. If this was not considered in establishing the coverage and a specific amount was required, then Andrew’s son could be left with a funding shortfall.
A common question asked regarding superannuation benefits and taxation is what happens if the proceeds are left to the estate? In this case the liability for taxation depends on who ultimately receives the benefits. If they are classed as a ‘taxation dependent’ then no tax will be payable, otherwise if the definition cannot be met, then the end-beneficiary will be liable for taxation.
It is important to consider the taxation implications of life insurance in superannuation. Although premiums look attractive as they can be paid ‘pre-tax,’ consideration needs to be given to the added complexities of life insurance claim payouts and taxation under superannuation.
Primoris Financial specialises in structuring coverage in the most cost efficient manner to ensure that the right life insurance and superannuation proceeds are received by the right person. Questions? Email Primoris Financial here