Life insurance is often taken out within the superannuation environment, but it is critical for consumers to consider all the tax implications associated with this.
For many, the decision to hold life insurance within a super fund is driven predominantly by the ability to claim a tax deduction for the premiums paid. Premiums paid for life insurance outside super will generally not be tax deductible. However, the tax consequences of payouts made on life insurance policies held in super are too readily overlooked.
Upon the death of a member for which the life insurance policy is held, a super fund will be eligible to make a claim, with no tax payable by the fund on the amount received.
But, there may be significant tax consequences for those payouts when they are paid to the ultimate beneficiary of the deceased's super benefits. Much depends on who the beneficiary is, such as whether they are a dependant or non-dependant, the age of the beneficiary and the deceased, and how the benefit will be paid.
It's important to remember super death benefits can only be paid to a dependant as defined under super legislation.
The tax implications for such benefits are then determined by reference to the definition of dependent under taxation legislation. A super death benefit could be paid to an adult child, but that child would only satisfy the definition of dependent for tax purposes if they were financially dependent on the deceased.
Tax dependants can receive lump sum death benefits tax free, whereas non-dependants can pay up to 31.5 per cent tax. Only tax dependants can receive death benefits as an income stream and depending on the age of the deceased, the age of the recipient and the nature of the taxable component, amounts will generally be tax free or eligible for a tax offset.
Where tax may be payable on death benefits paid to a tax dependant or a non-dependant, 'taxed elements' of a super interest - which are generally contributions and investments earnings - will be treated more favourably for tax purposes than 'untaxed elements'.
Life insurance payouts that make up a portion of a super death benefit can impact greatly on the tax payable because they are considered to be an untaxed element of the fund. Untaxed elements not only attract a higher rate of tax payable by the beneficiary than taxed elements, but are also calculated in such a way that the final untaxed element of the fund can end up being higher than the actual insurance payout.
Calculations of untaxed elements take into account the total super death benefit, deceased's date of death, their eligible service period, and the number of days until they would have reached retirement. The younger a person was on death, the higher their untaxed element is likely to be and therefore the higher the tax that may be payable by any beneficiary.
This all serves to demonstrate there are many considerations that need to be factored in when considering life insurance in super.
A person with a young family that could receive death benefits tax free as a lump sum may not be affected by an untaxed element of a potential insurance payout. For others, life insurance may not be affordable outside super, so the potential for tax payable is part of the 'price' for being able to take out life insurance.
It's important to remember tax consequences are not limited to the ability to claim a tax deduction for premiums paid - they can be quite significant for the beneficiary of any payouts.
A person's individual circumstances need to be considered and, if necessary, professional advice sought. Navigating the rules and regulations can be complex and the consequences of getting it wrong too significant not to give due consideration.
Liz Westover is head of superannuation at the Institute of Chartered Accountants in Australia.
