But what about insurance through an Self-Managed Superannuation Fund (SMSF)? Given younger people tend to have high debt, young children and are the ones in need of such coverage, how does this work in the SMSF ecosystem?

This article will look at Permanent Incapacity insurance through an SMSF, how the benefit is taxed and accessed when a member can no longer work.

Permanent Incapacity definition

In Australia superannuation generally cannot be accessed before you are at least 60 years of age.

However, under some very specific circumstances, the law allows a member to access their superannuation earlier.

One of those circumstances is Permanent Incapacity.

Permanent incapacity is defined in the superannuation regulations (Reg 1.03C) as follows:

“Permanent Incapacity” is defined as ill health (whether physical or mental) where the trustee is reasonably satisfied that the member is unlikely, because of the ill health, to engage in gainful employment for which the member is reasonably qualified by education, training or experience.

Fund trustees administer the release of benefits on the grounds of permanent incapacity. The trustee must be satisfied that the applicant is permanently incapacitated as defined in the regulations and the fund’s governing rules before a release can be made.

If there any permanent incapacity (or TPD) policies of insurance owned by the fund in the name of the member, the Insurance Underwriter needs to be satisfied the member is permanently incapacitated. They will collect medical evidence from the medical professionals and may also require their own independent medical examination before releasing the policy proceeds to the fund trustee/s.

Permanent incapacity is a condition of release with a nil cashing restriction. Therefore, the receiving member can choose whether they take the benefit as a lump sum, a regular income stream or a combination of both.

Taxation of Permanent Incapacity benefit

If the trustee is reasonably satisfied that the member has fulfilled a condition of release under the permanent incapacity definition, then the benefit would be taxed in the following manner (assuming no insurance proceeds):

Lump sum

Tax free component nil

Taxable component:

Under preservation age 20%

Aged 60 and above nil

Pension

Tax free component nil

Taxable component:

Under preservation age marginal tax rate

Aged 60 and above nil

Please note the Medicare Levy of 2% needs to be added to the tax.

As can be seen from the above, having a tax-free component is of great benefit if the benefit is taken in the form or a lump sum and/or a pension.

Case Study 1

· Jason was born on 1 January 1976 (48 years of age)

· His Service Period started on 1 February 1994

· Jason is no longer capable of gainful employment from 1 December 2024

· He satisfies the permanent incapacity condition of release

· He wishes to take his super benefit as a lump sum to pay off his mortgage

· Jason has $320,000 in super (all taxable component).

The tax would be as follows:

· $320,000 x 22% = $70,400 in tax*.

* Includes Medicare Levy of 2%.

Payment under the Income Tax Assessment Act 1997 – Superannuation Disability Benefit

The tax-free component of a superannuation benefit may be increased if it is paid to a member due to his/her disability and meets the definition of a Disability Superannuation Benefit (s995-1 of the Income Tax Assessment Act 1997).

To qualify for a Disability Superannuation Benefit, the following must have been complied with:

Disability Superannuation Benefit means a superannuation benefit if:

(a) the benefit is paid to a person because he or she suffers from ill health (whether physical or mental); and

(b) 2 legally qualified medical practitioners have certified that, because of the ill-health, it is unlikely that the person can ever be gainfully employed in a capacity for which he or she is reasonably qualified because of education, experience or training.

This is a much more stringent test of certification than a Permanent Incapacity benefit.

In relation to the payment of a lump sum disability benefit, the tax-free amount is increased and is the sum of:

· the tax-free amount; and

· amount of benefit x (days to retirement/ (service days + days to retirement)).

The date of retirement is for the purposes of a Disability Superannuation Benefit is normally the member’s 65th Birthday.

Case Study 2

Assume the same facts for Jason in the first Case Study, but now assume Jason satisfies the conditions that mean he is eligible to have the benefit treated as a Disability Superannuation Benefit. The benefit details are:

· Service period start date 1/02/1994

· Date member ceased to be gainfully employed 1/12/2024

· Date of normal retirement 1/01/2041

Days from ceasing work to normal retirement 5,876

Days from start date to normal retirement 17,137

Therefore the tax-free component is calculated as:

· $320,000 x (5,876/ (17,137)) = $109,723 tax-free component created.

So the lump components would be as follows:

· Tax free component $109,723

· Taxable component $210,277

· Total $320,000

The lump sum tax would now be $210,277 x 22% = $46,261*.

* Includes Medicare Levy of 2%.

Therefore being able to treat the lump sum as a Disability Superannuation Benefit reduces the tax by $24,139 (i.e., $70,400 - $46,261).

What about a pension?

A superannuation lump sum must be created to allow the increase in the tax-free component to be calculated. Whilst a Disability Superannuation benefit pension will have 15% tax rebate applicable to the income from the taxable component, the tax-free amount will not be calculated if the member requests the benefit to be paid in the form of an income stream, or if the money remains in the same superannuation fund.

If a disability income stream or pension is required, it may be more tax-effective for the member to roll over the Disability Superannuation Benefit to another superannuation fund in accumulation and then commence a disability income stream from that fund. This action may increase the tax-free component and allow for the eligibility for the 15% pension offset.

Case Study 3

· Richard, aged 40, suffers serious injuries in an accident and is no longer capable of gainful employment from 1 December 2024

· Two qualified medical practitioners certify it is unlikely Richard will ever be gainfully employed in a capacity for which he is reasonably qualified

· Richard has $200,000 in a retail super fund (all a taxable component)

· Richard’s retail super fund maintained a $800,000 Life/TPD policy

· The Underwriters are satisfied Richard is totally & permanently incapacitated

· The policy pays $800,000 TPD benefit to the fund

· Richard’s date of birth is 1 January 1984

· Richard’s service period started on 1 January 2002.

Subject to him satisfying the trustees and the provisions in the fund’s trust deed, Richard can access his benefit ($1,000,000 consisting of his member balance of $200,000 and $800,000 TPD proceeds).

If Richard starts an income stream from the retail super fund, it will be a commutable Account Based Pension. As the benefit is a Disability Superannuation Benefit, Richard is entitled to a tax offset equal to 15% of the income from the taxable component of the benefit. The disability superannuation benefit (income stream) will comprise wholly of a taxable component (i.e. the total $1,000,000 will be a taxable component).

Therefore, if Richard was to draw, say, 4% of $1,000,000 ($40,000), this amount will be added to his assessable income and taxed at his marginal tax rate, less a 15% tax offset.

If we assume a marginal tax rate of 32%* then the tax calculation is as follows:

$40,000 x (32%-15%) = $6,800 tax

* Includes the 2% Medicare Levy and ignores any other tax offsets or rebates.

Pension or Rollover?

However, if Richard were to roll the benefit over to another superannuation fund, say his own SMSF, and then commence a superannuation income stream, a tax-free component is created by the following calculation:

Amount of benefit x days to retirement/ (service days + days to retirement)

Days to retirement: the number of days from the day on which the person stopped being capable of being gainfully employed to his or her last retirement date.

Service days: the number of days in the service period for the lump sum.

In Richard’s situation the calculation to modify the benefit and create a tax-free component is as follows:

Benefit details

· Amount of superannuation lump sum payment $1,000,000

· Existing tax-free component of superannuation lump sum $0

· Service Period start date 1/01/2002

· Date member stopped being capable of being gainfully employed 1/12/2024

· Date of normal retirement (usually 65th birthday) 1/01/2049

Calculation

· Days from ceasing gainful employment to normal retirement 8,797

· Days from start date to normal retirement 17,167

Therefore $1,000,000 x (8,797/17,167) creates a

tax free component due to disability $512,437

Components of disability superannuation benefit

· Tax free component $512,437

· Taxable component $487,563

· Total $1,000,000

Richard could now start a superannuation income stream from his SMSF. Again, it will be a commutable Account Based Pension. But due to the modification for a disability superannuation benefit a large tax-free component of $512,437 (or 51.24% of the benefit) is created and would be received by Richard tax free if part of an income stream. The pension income attributable to the taxable portion of the income stream would be entitled to a 15% tax offset.

Once again, if Richard was to draw 4% of $1,000,000 ($40,000), this amount will be added to his assessable income and taxed at his marginal tax rate, less a 15% tax offset. But now there is a percentage of each payment that is now tax-free.

Assuming a marginal tax rate of 32%* the tax calculation is now follows:

$40,000 x (1-51.24%) x (32%-15%) = $3,316 tax

* Includes the 2% Medicare Levy and ignores any other tax offsets or rebates.

The same calculation for the creation of a tax-free component would apply if Richard decided to take the benefit from the retail fund as a lump sum. The lump sum tax on the taxable component would be levied at the rate of 22% as Richard is under Preservation age. However, no lump sum tax would be payable on rollover to a new fund to start an income stream and the assets used to pay an income stream are also exempt from tax. As Richard has satisfied a condition of release he has no cashing restrictions regarding his pension (i.e. it is fully commutable). Furthermore, if Richard has no tax dependents, the created tax-free component will reduce any lump sum tax payable upon his death by his beneficiaries.