A taxing question — superannuation and permanent disablement

It is important to note the responsibility of trustees is to “consider” insurance. It is not mandatory that insurance be taken out for the fund members.  

Where insurance is held through superannuation, the types of cover more commonly held include life, and total and permanent disability (TPD) insurance, followed by income protection (or salary continuance) insurance.

In this article, I will look more closely at TPD insurance held through super, and the tax consequences that may arise when a claim is admitted, and the member chooses to withdraw the benefit as a lump sum from the superannuation system, or commence drawing an income stream.

When considering accessing superannuation benefits of a member that has the misfortune of having become disabled, the first considerations is whether a condition of release has been met. Generally, in cases of permanent disablement, the relevant condition of release will be permanent incapacity. However, where a member has reached their preservation age, they may also be able to access their preserved benefit on grounds of having retired.  

In circumstances where the trustees of a superannuation fund have effected TPD insurance on the life of a member, the insurance policy is owned by the trustees of the superannuation fund.

When a claim is admitted, the insurance proceeds will be paid to the trustees of the superannuation fund in their capacity as the policy owner. Where the insurance was arranged after 30 June 2014, the insured benefit must be for the benefit of the member. Therefore, the insured member’s superannuation benefit will increase with the insurance proceeds.

Taxation of permanent incapacity benefits

There is a misconception, at least in some circles, that a benefit paid to a member, as a result of permanent incapacity, is tax-free to the member, irrespective of their age. Sadly, this is not the case.

Insurance proceeds will form a part of a member’s taxable component. However, it is not necessary for a superannuation benefit to include insurance proceeds for a benefit to be paid on grounds of permanent incapacity.

Consequently, if a member withdraws all or a part of their benefit, whether it includes insurance proceeds or not, the amount withdrawn is apportioned between their taxable and tax-free components. Lump sum benefits withdrawn from a taxed superannuation fund are taxed in the following manner:

* Plus Medicare levy

When a member meets the permanent incapacity condition of release and they wish to receive their benefit as an income stream (i.e. an account-based pension), and the member is under the age of 60, the portion of income attributed to their taxable component is included as assessable income and taxed at their marginal tax rate. However, they will be entitled to a 15 per cent tax offset, irrespective of their age.

Disconnect between tax and super laws, and life office practices

Subject to meeting certain conditions, a superannuation fund member who has met the permanent incapacity condition of release and wishes to withdraw their benefit as a lump sum, or roll it over to another superannuation fund, may qualify to have their benefit treated as a “disability superannuation benefit” (DSB).

Having a benefit classified as a DSB can be very advantageous to superannuation fund members, particularly those under 60 years of age.

A lump sum payment classified as a DSB results in the member’s tax-free component being increased to reflect the member’s future service period.

The Income Tax Assessment Act 1997 (Cth) (ITAA) defines a DSB as follows:

Disability superannuation benefit means a superannuation benefit if:

1. the benefit is paid to an individual because he or she suffers from ill-health (whether physical or mental); and
2. two legally qualified medical practitioners have certified that, because of the ill-health, it is unlikely that the individual can ever be gainfully employed in a capacity for which he or she is reasonably qualified because of education, experience or training.

The circumstances that will give rise to a superannuation benefit being a DSB are similar, but not identical, to the definition of permanent incapacity applied by many superannuation funds. Following is the definition as it appears in r.1.03C of the Superannuation Industry (Supervision) Regulations 1994:

Meaning of permanent incapacity

For subsection 10(1) of the Act, a member of a superannuation fund or an approved deposit fund is taken to be suffering permanent incapacity if a trustee of the fund is reasonably satisfied that the member's ill-health (whether physical or mental) makes it unlikely that the member will engage in gainful employment for which the member is reasonably qualified by education, training or experience.

It is important to note that while the regulations allow a benefit to be released when the “trustee is reasonably satisfied…”, it is not uncommon for APRA-regulated superannuation funds to impose additional conditions such as requiring medical certification of the incapacity. In the case of SMSFs, it is prudent to review the fund’s trust deed to ensure that the release of benefits on grounds of permanent incapacity meets any conditions imposed by the deed.   

The ITAA definition of a DSB is also similar to the requirement of many life insurers to support a claim for TPD benefits.

However, there is a disconnect between the three.

Simply having an insurer admit a TPD claim doesn’t necessarily mean the superannuation permanent incapacity condition of release has been met. Likewise, just because the permanent incapacity condition of release has been met, it doesn’t necessarily follow that a benefit paid by a superannuation fund will meet the requirements to enable it to be classed as a DSB and thereby allow the tax-free component to be modified.

To enable a DSB to be paid, “all the stars must be aligned”.

Modifying the tax-free component

When a member of a superannuation fund qualifies to receive a DSB, the tax-free portion of their superannuation benefit is increased by applying the formula set out in ITAA, s. 307-145.

The formula is:

Where:

Days to retirement – is the number of days from the day the member ceased gainful employment, until their last retirement date.

Last retirement date – is the date the member would normally have retired. This will generally be the member’s 65th birthday, unless their employment contract or other employment arrangement specifies an age when employment would cease.

Service days – the number of days in the member’s employment service.

Applying the formula

The following example illustrates the application of the tax-free modification:

Circumstances:

• Kathleen was born on 11 April 1975.
• She ceased gainful employment on 15 March 2019 as a result of becoming permanently incapacitated. Two medical practitioners certified her disablement.
• Kathleen’s eligible service start date was 1 July 1998. Her “retirement date” is 11 April 2040 (i.e. her 65th birthday).
• She has met the permanent incapacity condition of release and seeks to have her superannuation paid out as a lump sum benefit.
• Her superannuation benefit is $430,000 which includes an insurance TPD payment of $200,000. Her current tax-free component is $50,000.

By applying the formula to modify Kathleen’s tax-free component, her tax-free component is increased by $216,930.

Kathleen’s tax components, before and after modifying the tax-free component, are:

Modifying the tax-free component has resulted in tax on a lump sum withdrawal reducing from $83,600 to $35,875.

Does the modification apply in all cases?

For the tax-free component to be modified for a DSB, the superannuation benefit must be paid. That is, payment must be made to the member as a lump sum, or be rolled over to another superannuation fund.

If a member, having met a permanent incapacity condition of release, wishes to have their existing superannuation fund commence paying an account-based pension, the tax-free component is not modified (refer to the Australian Taxation Office’s Interpretive Decision ID 2009/125).

A member who otherwise qualifies for a DSB, but wishes to commence drawing an income stream rather than taking a lump sum payment, should consider rolling over their accumulated superannuation savings and commence their account-based pension with another superannuation fund, in order that their tax-fee component can be modified. The original fund should undertake the modification of the tax-free component before finalising the rollover.

In conclusion

While most reputable regulated superannuation funds will modify a member’s tax-free component as a matter of course when the circumstances permit, being aware of the intricacies of the taxation of superannuation benefits in more obscure situations can add tens of thousands of dollars’ value to your SMSF client’s financial position.

Peter Kelly, superannuation and retirement specialist, Centrepoint Alliance