IOOF TechConnect. Technical Insurance Guide. Adviser use only.

Transcription

1 IOOF TechConnect Technical Insurance Guide Adviser use only.

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3 IOOF TechConnect Technical Insurance Guide Contents Introduction 2 Term life insurance 8 Terminal illness benefit 16 Total and permanent disablement insurance 17 Income protection insurance 22 Trauma insurance 26 Expats, inpats and insurance 27 Centrelink and insurance payments 28 Business insurance 30 1

4 Introduction The principal legislation and regulations concerning matters relating to life insurance policies are the Life Insurance Act 1995 (LIA 1995), Life Insurance Regulations 1995 (LI Regs), the Insurance Contracts Act 1984 (ICA 1984) and the Insurance Contracts Regulations 1985 (IC Regs). What is life insurance? Life insurance is a contract between two parties (the policyholder and the insurer) where, contingent on the payment of premiums and as agreed within the contract in the event of death, disablement, temporary disablement or a critical illness, a payment will be made to the policy owner. The primary references are contained in the LIA 1995 (in particular sections 9 and 9A). Section 9 provides a definition of a life policy, whereas section 9A outlines continuous disability policies. Section 9A envisages benefits payable in the event of accident injury or sickness but it specifically excludes health insurance. Duty of disclosure Section 21 of the Insurance Contracts Act states; An insured has a duty to disclose to the insurer, before the relevant contract of insurance is entered into, every matter that is known to the insured, being a matter that: a the insured knows to be a matter relevant to the decision of the insurer whether to accept the risk and, if so, on what terms; or b a reasonable person in the circumstances could be expected to know to be a matter so relevant. On 28 June 2013, Parliament passed the Insurance Contracts Amendment Act 2013 amending the duty of disclosure requirements and misrepresentation. The new provisions are phased in between 28 June 2013 and 28 December The key changes for life insurance are amendments to the following sections: Section 21 clarifies the duty of disclosure test and extends it via sections 21A and 21B for eligible contracts of insurance. Section 22 amends the notification to the prospective insured to include a clear written explanation of the duty of disclosure and how long it applies. Section 27A enables insurers to unbundle a policy where non-disclosure or misrepresentation occurs. To treat each type of cover as if they comprised of two or more separate contracts. Section 29 extends the insurer s ability to alter the sum insured beyond the three year limit where the insured fails to comply with their duty of the disclosure, or is found to have made a misrepresentation at any time on discovery of the non-disclosure or misrepresentation. Section 32 clarifies when the duty of disclosure applies to a member of a super or other group scheme and when the life insurance cover takes effect. If an insured breaches their duty of disclosure or makes a misrepresentation after joining, but prior to life insurance cover being provided to them by the group, the non-disclosure or misrepresentation is deemed to have occurred prior to the commencement of the contract. 2

5 IOOF TechConnect Technical Insurance Guide Case Study: Duty of disclosure remedies Any failure to disclose (even if unrelated to the claim) can be enough to void an insurance contract. But what do you do if a client comes to you and says that they didn t disclose a condition on an old insurance policy that has been in place for years? This example illustrates the correct procedure. Peter the plumber meets with Mark the financial planner. Peter has an old insurance policy (for life, TPD, trauma and income protection) and is wondering if it s worth keeping. Mark is about to say most definitely (as the insurance company underwriting the policy has a good reputation and has won insurer of the year several times since the policy has been written). However, Peter lets him know that he failed to disclose that he had Hepatitis C (Hep C) at the time of the policy being written. Peter got the Hepatitis C as a result of the blood transfusion. Peter still wants cover if he knows that he will be paid in the event of a claim. Mark lets him know that had he disclosed his Hep C status at the time the conditions may have been quite different. As a result Peter wants to cancel the policy because he realises his non-disclosure would void the policy. Mark has a better idea. He rings around several insurance companies and finds out that they would over Peter cover at a 300 per cent loading. He suggests that Peter applies for the cover, gets it and then consider what to do with the old policy. Peter agrees and they put the new policy in place. Mark then drafts a letter to the old insurance company for Peter to sign stating that he failed to disclose his Hep C at the time of the application. They aren t sure what the old insurance company will do. Might they offer a third of the level of cover? Might they say we will continue to cover you so long as you pay what you should have paid (as we would have loaded the policy)? Might they refund the policy? Might they just cancel and offer no refund? Much to both Mark and Peter s surprise, the old insurer voids the policy and gives a full refund of all premiums paid to date. This amounts to several thousands of dollars. Both Mark and Peter are extremely pleased at the outcome because it s an unexpected windfall and Peter now has some extra cash to pay for the policy. Lesson to be learned: Have an alternative strategy in place before cancelling a pre-existing policy. Don t assume that an insurer won t offer an agreeable outcome if a case of non-disclosure is corrected. Correct cases of non-disclosure by writing to the insurer. Don t let such a situation continue. Replacement Policy Advice Advisers should also remember to fulfill the requirements under the Corporations Act 2001 section 947D when replacing one insurance policy with another whether inside or outside super. These include documenting in the Statement of Advice: any charges the client will or may incur as a result of the disposal or reduction any charges the client will or may incur as a result of the acquisition or increase any pecuniary or other benefits that the client will or may lose (temporarily or otherwise) as a result of taking the recommended action information about any other significant consequences for the client. As a result of the stringent best interests requirement, in addition to s947d, undertaking research into all facets of the from fund has become more important than ever. It is now not just a case of know your client, know your product but know the existing product as well as the new product. Some of the impacts of replacing the client s policy include: 13 month suicide clause may begin to run again wait period on the new TPD policy may be longer new policy may not have a TPD buy back on it new policy may be a standard not a premier policy new policy may be an indemnity not agreed policy new policy may mean that the client has to wait longer for their benefits due to longer waiting periods automatic indexation of the sum insured may be lost premium type may change (stepped or level premiums) benefit period may not be as long under the new policy as the old policy new policy is via super and the cover stops at age 65 or 70 3

6 new policy is via super and once the member turns 65 they must be eligible to contribute to maintain the policy new policy is in a super fund with an older ESP start date. This means that the taxation on the TPD benefit may be higher new policy is in a SMSF and this means if the clients are married and choose to get divorced and separate their assets there may be tax implications of moving the insurance policy that are adverse. The policy may not be able to be assigned to a new fund or may be able to be assigned but subject to higher premiums insurer has a right to cancel the new policy for non-fraudulent non-disclosure within the first three years of the policy. CFP v Couper replacement policies and what can go wrong Case study: Cheaper cost to client does not mean it is in the best interests of client The recent case of Commonwealth Financial Planning Ltd v Couper [2013] NSWCA 444 illustrates that merely recommending a policy that is cheaper will not satisfy the best interests requirements of section 961B of the Corporations Act 2001 (Cth). That case involved a bank planner recommending that a client replace another bank s life insurance policy with their own. The new policy was, without a doubt, cheaper however, the insurer attempted to void the new policy for non-fraudulent nondisclosure pursuant to s 29(3) of the Insurance Contracts Review Act 1984 (Cth) (ICRA84). The new planner was unaware of section 29(3) ICRA84, which allows an insurer to void a policy for non-fraudulent non-disclosure. As a result, because they were unaware of the section they were unable to disclose this on their replacement policy advice record as required under section 947D of the Corporations Act. The facts The existing policy had been in place for many years. Had the insured retained the old policy they would have been paid out under the policy. The insured had pre-existing conditions that were not disclosed on the new electronic application form. The planner did not provide the client with a paper based copy of the application form so that they could check their answers. The planner didn t disclose the existence of section 29(3) ICRA84 and the consequences of replacing one policy that was no longer subject to that Act with a policy that was subject to that section. The planner and their employer were held liable for misleading and deceptive conduct and negligence. The court found that had the insured been fully informed of the consequences of cancelling the policy then they wouldn t have cancelled it. What can we learn from CFP v Couper? The obvious lesson from this case is the ability of an insurer to cancel a policy in the first three years of its existence. This then always makes a pre-existing policy of more than three years in duration more valuable than a new one. However, a number of other salient lessons can come from this case: Make sure the client knows about section 29(3) of the Insurance Contracts Review Act. Make sure the existence of section 29(3) is disclosed in the SoA. Print out the application form and medical statement of the applicant and give them a copy. Explain the duty of disclosure and impact of failing to disclose both in writing and verbally. Make sure that the client understands that it is their duty not yours. Don't base reccomendations on cost alone. Ensure that you are acting in the clients best interest when dealing with a recommendation for insurance which involves replacing one policy with another. 4

7 IOOF TechConnect Technical Insurance Guide Stamp duty and life insurance Life insurance policies are generally subject to stamp duty levied by individual states. Insurance duty is levied on the life insurer and is reflected in premium rates. Each state s definition of life insurance varies as does the rate of duty if the life insurance is risk-only or has an investment component. With reference to the following table we are illustrating risk only policies. Death cover is clearly insurance, but standalone TPD may be treated as a life insurance rider, along with income protection and trauma insurance. Most states will treat life insurance riders as general insurance. Duty on general insurance is a percentage of the premium and paid on an ongoing basis. Life insurance duty, except for those who reside in South Australia, is applied at the start of the policy (or individual cover if under a group policy). State Life insurance duty General insurance duty (ongoing) NSW 5% first year s premium (includes TPD) 5% premium includes trauma and income protection. VIC Nil (death cover but all riders treated as general insurance) 10% premium includes bundled TPD, trauma, and income protection. Qld 5% first year s premium 9% premium includes separate TPD, trauma and income protection. SA 1.5% premium ongoing 11% premium includes bundled TPD, trauma and income protection. WA Nil (death cover and bundled TPD) 10% premium includes TPD if separate premium, trauma and income protection. Tas 5% first year s premium 10% premium includes trauma, income protection and standalone TPD. ACT 2% first year s premium (including TPD) 4% premium includes trauma and income protection. NT 5% first years premium 10% premium include trauma and income protection. New developments in Victoria Victoria recently abolished duty on life insurance from 1 July Life insurance is restricted to death cover only, and any TPD or trauma benefit attached to the death cover is defined as a life insurance rider and treated as general insurance. In the past in Victoria bundled TPD and/or trauma with death cover was an ancillary benefit and treated as life insurance. The effect of this could mean a jump in premiums for Victorians taking out new policies or cover that includes TPD. In WA, duty on life insurance has been abolished for some years, however the TPD component of a policy is only treated as general insurance if the premium is separately identifiable. 5

8 Life insurance ownership A life insurance policy may be owned by one or more legal entities. The owner and nominated beneficiary do not have to be original parties to the contract. The LI Act 1995 (LIA) section 10 defines the policy owner as either: the person to whom the policy is issued if the rights of that person under the policy have been assigned under the LIA or transferred by the operation of the policy, the person who has those rights. The policy owner may cash, convert or assign the policy and direct to whom payment of the proceeds are to be paid (for example to the nominated beneficiary). The policy beneficiary is the person who will receive the proceeds and need not be the policy owner. Assignment of ownership An assignment takes place when a dated memorandum of transfer is completed by the transferor and transferee, and registered by the life insurance company. Some life insurance policies, cannot be assigned. Ownership options Self-ownership Joint tenants Tenants in common Equitable interest Third party ownership Description The life insured is named as the policy owner. This is the most popular form of ownership and minimises potential capital gains tax issues. Jointly owned by two or more legal entities. Where one of the owners dies ownership vests absolutely or equally between the surviving joint tenants. There cannot be disproportionate shares. Each owner s share must be specified and remains with the owner and subsequently to their estate. There is no rule in respect of the percentage share, nor the number of tenants in common. May be required by a third party, such as a lender institution holding a policy as collateral to a debt. The policy may have an unregistered assignment on it. If in case of death, the third party may register the assignment. The owner may be the trustee, business associate, a company or anyone who needs to protect themselves against the risk of financial loss on the death or disablement of the life insured. Business ownership A company as a legal person can enter into a contract as policy owner. Proceeds will be used for either revenue or capital purposes. Trustee ownership When completing an application or transferring a policy to a trust (which is not a super trust), the insurer will only accept the risk and issue the policy in the names of the trustees (unless it is to a super fund). There may be CGT implications when a trustee owns a life insurance policy. Income Tax Assessment Act 1997 (ITAA 1997) s provides protection to certain trustees including super trustees. 6

9 IOOF TechConnect Technical Insurance Guide Cutting the cost of insurance premiums by using super There are funding advantages a person can derive from holding their death and TPD cover within super compared to outside. This is usually displayed in a simplistic example as shown in the following case study Case study: Funding efficiencies Jack (aged 45) is married to Dianne (aged 41). Jack earns $100,000 per annum. Dianne is taking time out of the workforce to raise their young family. They have a mortgage. Their adviser assesses their goals and financial situation and recommends $1,000,000 in life insurance so that Dianne can pay off their debts and replace Jack s income if he dies. The premium for this insurance is $1,181 p.a. The adviser also explains it is more cost effective if he takes out his cover in super, this is because if he arranges salary sacrifice into his super he is able to use pre-tax dollars. Otherwise if Jack purchases his cover outside of super he will pay $1,181 per annum from his after tax dollars. After taking into account his 39 per cent marginal tax rate (including Medicare levy), the pretax cost would be $1,936 per annum. By insuring through super he has pre-tax savings of $755 per annum in the first year (or $461 per annum after tax). The following table illustrates how this saving arises. Outside super (after tax salary) Inside super (salary sacrifice) Funding the cover through super provides immediate year one tax efficiency however the client may wish to have one of a number of different outcomes. For example, they may wish to fund cover and increase super benefits through additional contributions whilst minimising the impact on cash flow. So the fund passing on the benefit of this deduction to the member by offsetting that assessable income may be only half the story. Consideration also needs to be given to the method of funding this cover within super. The member has two options to fund the cover: 1 Where they have accumulated investment benefits, they can elect to simply have the cost deducted from those benefits; or 2 They can make additional contributions to fund the cost of the cover. It is with the second option that a clever strategy can maximise the cash-flow and super benefits of having the cover held within super. Premium $1,181 $1,181 Plus tax and Medicare Levy at 39% Pre tax salary received or salary sacrificed $755 N/A $1,936 $1,181 Pre tax saving N/A $755 After tax saving N/A $461 7

10 To show the potential benefits of funding cover through super, we consider the following case study. Case Study: Funding efficiency considerations Amy is an employee with a salary package of $109,500 (including super guarantee). Currently she has no insurance cover, however her financial adviser has suggested taking death and TPD cover equivalent to a premium of $4,000 per annum. She has agreed, and her financial adviser investigates five scenarios for funding this cover as follows: 1 Insurance policy is owned by Amy who funds the premium out of her after-tax salary. 2 Insurance policy is owned within super with Amy funding the premium by making an additional equivalent personal contribution to super. For the purposes of this scenario, we assume that the contribution is made to the same fund to which her employer contributes. 3 Insurance policy is owned within super with the premium funded solely from Amy s accumulated benefits. 4 Insurance policy is owned within super with Amy funding the premium by salary sacrificing an additional amount of her pre-tax salary so that her employer contributions are increased by the amount of the premium. 5 Insurance policy is owned within super with the premium funded by an additional employer contribution equivalent to the amount of pre-tax salary dollars that would have been required to fund the premium in after tax salary dollars. Given a marginal tax rate of 39 per cent (including Medicare Levy), the additional employer contribution required is calculated as follows: Additional employer contribution = Cost of premium (1 MTR) = $4, = $6,557 It is worthwhile recognising here that the beneficial outcomes shown below for scenarios 4 and 5 are only relevant to death and TPD cover since an individual is eligible to claim a personal tax deduction for premiums related to income protection cover. The table below highlights Amy s net annual income (cash-flow), and net annual increase in super benefits (excluding investment earnings), under the five scenarios outlined above. Scenario 1 ($) Scenario 2 ($) Scenario 3 ($) Scenario 4 ($) Scenario 5 ($) Salary (take home) 100, , ,000 96,000 93,443 Tax and Medicare levy 26,947 26,947 26,947 25,387 24,390 Income situation Income after tax 73,053 73,053 73,053 70,613 69,053 Premium 4,000 Personal contribution 4,000 Net income 69,053 69,053 73,053 70,613 69,053 Taxable super cont n 9,500 9,500 9,500 13,500 16,057 Premium cost 4,000 4,000 4,000 4,000 Super situation Net taxable contribution 9,500 5,500 5,500 9,500 12,057 Tax 1, ,425 1,809 Personal contribution 4,000 Net super increase 8,075 8,675 4,675 8,075 10,248 Total income & super increase 77,128 77,728 77,728 78,688 79,301 Annual benefit over scenario ,560 2,173 The above table shows that, of the five scenarios, if the focus was to achieve the best outcome in terms of gross cash-flow and increase in super benefits, the best approach for Amy would be to salary sacrifice the amount of pretax salary that would have been required in after tax dollars to fund the premium personally (scenario five). 8

11 IOOF TechConnect Technical Insurance Guide Scenario two provides a marginally better result from a super benefit perspective due to the premium cost providing a tax deduction. However it is worth noting that if the personal contribution was made to a risk only super policy, no assessable income would exist for the premium deduction to be offset against. In this circumstance, Amy s outcome under Scenario two would be the same as scenario one. Where cash-flow is the predominant concern, we find that scenarios three and four provide a better outcome. Under scenario three, this is simply due to the premium being funded solely from accumulated benefits without making additional contributions. However, Amy s retirement benefits will be compromised. Under scenario four, the higher cash-flow results because only $4,000 of pretax salary is required to fund the premium in super whereas $6,557 of pretax salary would have been required to fund the $4,000 premium after deducting 39 per cent tax (including Medicare levy) had the insurance been held outside super. We could also take it one step further by considering a lower income earning spouse. The primary income earner could look at salary sacrificing further, and then splitting part of their contributions to their spouse s super to fund their insurance. Of course, the entire circumstances of the individual would need to be considered before deciding on the optimal approach from a super benefit and cash-flow perspective. For example: is the person eligible for a government co-contribution if they opt to fund the premium via a non-deductible personal contribution? what is the effect of a lower marginal tax rate? Funding options for insurance as discussed in this paper should be an important consideration in determining the ownership structure of a person s life insurance cover, in conjunction with other estate planning factors such as taxation of benefits and beneficiary option flexibility. 9

12 Term life insurance Life insurance non-super Life insurance is comparatively simple when it is established outside of super and the premium is paid by a client. The premium is not tax deductible and the proceeds from the policy are exempt for capital gains tax purposes. 1 The proceeds are not usually subject to capital gains tax unless the proceeds: are received by a person, other than the original beneficial owner of the life insurance policy are received by a person, who had acquired the policy for money or other consideration. Life insurance through super The super environment is a tax efficient vehicle to save for retirement. With that in mind, the inclusion of life insurance within super can overcome some client specific funding issues and provide strategic planning opportunities. From a super perspective, upon death the insurance proceeds are paid by the insurer to the trustees of the super fund. The proceeds from the life insurance policy should be included within the deceased s super account and added to the taxable component of the account. Death is a compulsory cashing event under the SIS Act. The trustee will then pay the proceeds of the life insurance policy, along with the deceased member s account balance, to a super dependant or the Legal personal representative of the deceased. The taxation treatment of a payment (a lump sum death benefit) will depend on whether the person is classified as a dependant for taxation purposes (a death benefits dependant). SMSFs and life insurance When formulating the fund s investment strategy, SMSF trustees are now required to consider whether they should hold insurance policies for the members. While there is no requirement that the fund obtains insurance cover, the need (or otherwise) must be actively considered. If the trustee determines insurance is required, and that it should be held within the SMSF, the decisions need to be documented to form part of the fund s investment strategy. This may be achieved via a separate minute of the trustee. Also, as part of the regular review of investment strategy, trustees will need to document the review of insurances as part of that strategy. The notation could be as simple as: The trustees have considered the insurance needs of members of the fund. They have determined that the insurances held by the members within the fund remain appropriate. Alternatively it could be: The trustees have considered the insurance needs of members of the fund. They have determined that it remains appropriate for the fund not to hold insurance policies for the members. However, if trustee s documentation of the assessment of insurance needs is too brief, they risk the potential for future claims to be made against them by disgruntled next of kin. Trustees may therefore wish to undertake and hold a more detailed analysis of their insurance needs in a separate document (which could be a statement of advice provided by a financial planner). A review of a fund s investment strategy to consider member s personal insurances may provide a timely prompt to ensure that other insurances are in order. If funds have property (such as an investment property), they should ensure that the property is adequately insured. This includes the need to hold public liability insurance for the property to ensure that the trustees are covered for any injuries that may occur to visitors to the premises. If the SMSF has purchased a collectable since 1 July 2011, the collectable is required to be insured in the name of the trustee. If clients already held collectables in the fund as at 30 June 2011, insurance will be required from 1 July Trustees need to be aware of their obligations and are likely to require assistance from financial advisers to assess their insurance needs. This can include assessing the benefits of holding various types of insurance within the SMSF versus outside of super Income Tax Assessment Act (ITAA) 1997 s

13 IOOF TechConnect Technical Insurance Guide SMSFs, insurance and borrowing Additional complexities arise where borrowings have been used to acquire a property. Where only spouses are involved, the simple solutions of paying death benefits as an income stream or holding insurance outside of super may be appropriate. In business partner arrangements, a cross-insurance arrangement may be used. Under this strategy the members take out an insurance policy on each other. The premiums are paid from each other s account and are not tax deductible to the fund. When one member dies the proceeds are received into the surviving member s account and the surviving member trades cash for the deceased member s share of the property. The deceased member s death benefit can be paid in cash and the surviving member retains property. It is essential that the SMSF trust deed allows this type of structure and does not simply require the proceeds of any policy of insurance held on behalf of a member to be credited to their accumulation account and paid as a death benefit to dependants. Issues may also arise in respect of the surviving member s ability to service the loan. IOOF SMSF Insurance IOOF SMSF Insurance, is straight forward life cover with the option of linked (Any Occupation or Home Duties) TPD. It is easy to apply for via a short personal statement for sums up to $1.5M. It is available to all SMSF members/trustees and is administered and underwritten for IOOF by Zurich. For clients with existing cover there is a transfer protocol to bring their covers from other insurers (up to $2M in total) to IOOF SMSF Insurance. Other features: Entry age to 64, cover expires age 70 Unlimited death cover and up to $3 million TPD cover It has found favour with accounting practices in their intermediary role of establishing and administering SMSFs thanks to its simplicity. For end user applicants who are over age 50, IOOF SMSF Insurance is particularly competitive when compared to retail insurance policies. A 50 year old male with $1 million Life / TPD cover would typically save around $1,000 per annum. Premium savings improve with age to the extent that a 60 year old with $1 million Life/TPD could potentially save up to $6,000 in annual premium when compared to retail cover. All the information you need including Key Features, access to quoting tools, PDS etc. are available at the following link: SMSFs and cross insurance As at March 2014 there were 506,285 SMSFs with 962,263 members of which 22.7 per cent were single member funds and 69.2 per cent had two members. According to the same ATO SMSF statistical report there are only 2,781 LRBA s in existence. However, many more SMSF trustees consider such an investment strategy and seek informed advice from their financial advisers. The challenge is how do we ensure a member s death or disability does not negatively impact an existing LRBA arrangement? Why does the traditional insurance in super structure (self-insurance) not work? The sole purpose test, empowers the trustee to provide insurance for the purpose of death, terminal illness, permanent incapacity or temporary incapacity benefits The fund may claim a tax deduction for premiums when insurance is attached to the members account for the purposes of providing benefits to a member or their beneficiaries. However in the event of a claim the proceeds must be credited to the members account. The proceeds cannot be used to retire fund debt to protect fund assets underpinning other fund members account balances. The debiting of premium costs must mirror the crediting of the insurance proceeds, hence we come to the cross insurance strategy. The first consideration is that the trust deed and investment strategy must enable a cross insurance strategy to be implemented. Importantly, the fund cannot claim a deduction for the premiums under s of ITAA 1997 because there is no connection between the premium payment and the proceeds providing a benefit for the life insured. How does cross insurance work? The SMSF trustee takes out a policy over a member s life and the premiums are debited from the other members accounts. In the event of a claim the other members accounts are credited with the insurance proceeds. The ATO has confirmed this does not constitute an allocation from reserves. The insurance premiums are not deductible. (ATO Taxation Ruling TR 2012/6 Example 9) How cross insurance works is best displayed in the following case study. smsf_insurance Offer documents are available only in electronic format. 11

14 Case Study: How does cross insurance work? Jack (60) and Dianne (55) have a two member SMSF with the following assets: Jack and Dianne SMSF Assets Amount of investment ($) Property 1,500,000 Liquid assets 400,000 Total assets 1,900,000 LRBA loan debt (900,000) Net equity 1,000,000 Account balances Jack 700,000 Dianne 300,000 If Jack died the fund would have to pay a $700,000 death benefit to Dianne. However, the fund only has $400,000 in liquid assets meaning there is a $300,000 shortfall. Should Dianne die the $300,000 has to be paid to Jack. The $300,000 could be funded from liquid assets or by using a cross insurance strategy similar to that proposed for Jack. The trustee could take out an insurance policy for between $300,000 and $900,000 on the life of Jack and debit the premiums from Dianne s member account. Option one If $300,000 the insurance proceeds and the $400,000 would be sufficient to pay out the death benefit. Option two If $900,000 the insurance proceeds could totally retire the debt. Debiting Dianne s account for the premium means it is fair and reasonable to credit her account with the insurance proceeds Option one Jack and Dianne SMSF $300,000 Insurance Assets Amount Property $1,500,000 Liquid assets $700,000 Total assets $2,200,000 LRBA loan debt ($900,000) Option two Jack and Dianne SMSF $900,000 insurance Assets Amount Property $1,500,000 Liquid assets $1,300,000 Total assets $2,800,000 LRBA loan debt ($900,000) Net equity $1,900,000 Account balances Jack (deceased) $700,000 Dianne $1,200,000 The trustees have two choices: Pay Jack s death benefit of $700,000 out of liquid assets (and reduce the debt to $300,000) Retire the debt in full and pay a death benefit pension or a combination of death benefit lump sum and pension. Option 2. Jack and Dianne SMSF $900,000 Insurance Assets Death lump sum only ($) Death pension only ($) Property 1,500,000 1,500,000 Liquid assets 1,300, ,000 Total assets 2,800,000 1,900,000 LRBA loan debt (900,000) 0 Net equity 1,900,000 1,900,000 Account transactions Jack (deceased) 0 0 Dianne 1,200,000 1,200,000 Lump sum payment (700,000) 0 Death pension capital 700,000 SMSFs are flexible and the members/trustees have the ability to structure optimal solutions to suit their individual circumstances. Net equity $1,300,000 Account balances Jack (deceased) $700,000 Dianne $600,000 12

15 IOOF TechConnect Technical Insurance Guide Estate planning implications Deciding to hold life insurance within super means a client who is a member of the fund is unable to consider their super account as an estate asset that will be dealt with via their Will, unless a binding nomination directs payment to the deceased s Legal Personal Representative. The following main factors need to be considered: the correct beneficiary/dependant(s) of the deceased member will receive the proceeds the taxation implications whether a lump sum, an income stream or a combination of both is available and which is appropriate. A few different considerations need to be taken into account: Payment of a lump sum death benefit into the client s estate Clients need to decide whether or not their super account balance should be paid into their estate and dealt with via their Will. To ensure this a client needs to make certain the trustee of the super fund is legally bound to pay the lump sum death benefit into their estate by using a valid binding death benefit nomination. Consideration of the lump sum death benefit tax liability is important. In simple terms, the executor must determine whether the beneficiary who receives the lump sum death benefit payment is classified as a dependant for taxation purposes (a death benefits dependant) or not and if applicable, withhold the appropriate amount of tax. Important: Payment of lump sum death benefits is common for clients who wish to benefit their relatives (such as a brother or sister) or a charity. These beneficiaries do not qualify to receive a payment directly from the client s super fund because they fail to satisfy the definition of dependant for super purposes. The advantage of using the client s estate is that it can ensure that an equivalent amount is paid to the required beneficiary. Payment of a lump sum death benefit into a discretionary testamentary trust A discretionary testamentary trust is a trust that is created within a Will but does not take effect until death. While the assets of the testamentary trust may be controlled by the intended beneficiary, as trust assets they do not form part of the beneficiary s estate. A discretionary testamentary trust can provide tax effective income to the deceased s spouse and children. One of the main sources of funding for the discretionary testamentary trust is a client s super account (including life insurance), however this advice needs to be carefully constructed in conjunction with an estate planning specialist. Important: If the client wants to make certain the trustee of the super fund will be legally bound to pay the lump sum death benefit into the client s estate and in turn into a discretionary testamentary trust, a binding death benefit nomination should be used. Failing to ensure the trust deed for the discretionary testamentary trust has been correctly drafted can result in lump sum death benefit taxes applying even if the main beneficiaries of the trust are death benefits dependants for taxation purposes (such as a spouse or minor children). Providing a lump sum benefit to a dependant from the deceased client s super fund To receive a lump sum benefit from a super fund upon death, the beneficiary/dependant must be classified as a dependant for super purposes. To ensure the lump sum death benefit will be tax-free, the beneficiary/ dependant must be classified as a dependant for taxation purposes (a death benefits dependant) at the date of death of the member. Providing an ongoing income stream to a dependant (such as a spouse or child) To be eligible to receive a death benefit income stream from a super fund upon death, the beneficiary/dependant is not only a dependant for super purposes but also one of a limited number of death benefits dependants for taxation purposes (such as a spouse or child under 18, a child under 25 who is financially dependent or a disabled child). Note: Financially independent adult children are ineligible to receive death benefit income stream and a lump sum death benefit must be received. Important: There continue to be some super funds that will not pay a child pension upon the death of a member parent. Understanding which super funds have this restriction could provide an adviser with a reasonable basis for recommending against the use of that super fund in appropriate circumstances. 13

16 Types of nominations A member can make either a binding or non-binding nomination (only one can be selected). The most appropriate nomination will depend on the client s personal circumstances taking into account the following: taxation implications the type of benefit to be paid whether the estate is a better mechanism to distribute or retain the lump sum death benefit within a trust structure. Important: If your client nominates their legal personal representative, their super account will form part of their estate and be distributed in accordance with their Will or if intestate in accordance with the state laws in which they were domiciled. A client should seek advice from a solicitor specialising in estate planning. Non-binding nomination If trustee discretion exists, the trustee will make the final decision to determine which of the deceased member s dependants and/or legal personal representative will receive the deceased members benefit and the proportions payable to each. A nomination will be taken into account when the trustee determines who to pay the benefit to. The trustee of the fund will take into account circumstances that are relevant to making a decision. Binding nomination If your client has a valid binding nomination in effect at the date of their death, the trustee must pay the benefit to the dependant(s) or to the legal personal representative) that the client has nominated in the proportions that the client has set out in their nomination. A valid binding nomination remains in effect for three years from the date it was first signed, last amended or confirmed. The following conditions that must be met to ensure that a binding nomination is valid: the nomination must be in favour of one or more of your client s dependant(s) and/or estate. each nominated dependant must be an eligible dependant at the date of nomination and at the date of your client s death. the allocation of the benefit must be clearly set out. the total benefit must be allocated (the percentage nominated must add up to 100 per cent) otherwise the entire nomination will be invalid. the nomination must be signed and dated by your client in the presence of two witnesses both of whom are over 18 years of age and are not nominated to receive the benefit. the nomination must contain a declaration signed and dated by each witness stating that the notice was signed and dated by your clients in their presence. Super trust deed clauses A super fund is governed not only by legislation, but also by rules set out in the fund s trust deed. A trustee has the ability to apply their discretion in relation to payment of death benefits (assuming no valid binding death benefit nomination is in place), provided that this discretion is within the law and does not breach the trust deed of the super fund. In some instances the trust deed of a super fund may state that a death benefit must be paid as a lump sum or to the estate of the deceased member which could pose a problem if the spouse wanted to receive a death benefit income stream instead or if the estate may be subject to a legal challenge under the relevant state law. SMSFs and SAFs are able to use trust deed clauses in the manner of non-lapsing binding nominations. Binding nominations and powers of attorney For APRA regulated super funds, a member cannot delegate to their attorney via a general power of attorney the ability to create a new or alter an existing binding death benefit nomination. These constraints do not necessarily apply to self-managed super funds (SMSFs). Depending on the SMSF s trust deed, an attorney may be able to nominate a beneficiary or alter an existing nomination. Important: Advisers should be aware that clients who have lost legal capacity could be negatively impacted by changing super. A new binding death benefit nomination may not be permitted with the new super fund and this means the fund rules where there is no nomination will apply. 14

17 IOOF TechConnect Technical Insurance Guide Taxation of death benefits lump sum death benefits Super death benefits paid as a lump sum to death benefits dependants for taxation purposes are classified as non-assessable nonexempt income which is entirely tax-free. Death benefits dependant Tax-free component Taxable component Element taxed Element untaxed Dependant Non-assessable non-exempt income (100% tax-free) Non death benefits dependant Non-assessable non-exempt income (100% tax-free) 17%* 32%* * Inclusive of two per cent Medicare levy. For non-death benefits dependant, the taxable component (element taxed) will be taxed at 15 per cent plus the Medicare levy and the taxable component (element untaxed) will be taxed at 30 per cent plus the Medicare levy. A taxable component untaxed element occurs when the lump sum death benefit is paid to a non-death benefits dependant and the super fund has claimed a tax deduction for the cost of the insurance premiums as outlined in the case study of Alison. Important: The taxation treatment of lump sum death benefits from super is widely understood and taken into account when advising clients. However, advisers may be unaware of the true cost which can result in a client losing government assistance payments and paying more personal income tax. Impact of the lump sum death benefit being paid into the estate If the lump sum is paid to the estate, the tax treatment depends upon which beneficiaries will receive the payment from the estate. The taxation treatment is the same as if the payment is made directly from the deceased client s super fund to the beneficiary except the Medicare levy is not applied. Two main outcomes may occur: If the beneficiary is a death benefits dependant for taxation purposes (such as a spouse), the estate will not withhold tax from the lump sum death benefit (it will be tax-free). If the beneficiary is not a death benefits dependant for taxation purposes (such as a financially independent adult child like in the following case study) then the applicable tax should be withheld by the executor (as outlined previously but Medicare levy does not apply). 15

18 Case study: Lump sum death benefit tax Alison s mother passed away in December and her super account valued at $510,000 (including life insurance proceeds of $400,000) was recently paid to her as a lump sum death benefit from the trustee of her mother s super fund. Alison (age 26) is classified as a non-death benefits dependant for taxation purposes and this means tax will be payable. The components of the lump sum death benefit payable to Alison are outlined in the following table. The effective rate of tax payable on the lump sum death benefit is per cent whilst the net payment will be $402,774. Though the table includes a Medicare levy of $10,200 this will not be withheld by the Executor. Components and taxation of lump sum death benefit Gross payment ($) Tax rate* (%) Tax withheld ($) Net payment ($) Taxable component taxed element 373, , ,724 Taxable component untaxed element 136, ,788 93,051 Total 510, , ,775 * Includes two per cent Medicare levy. Important: The same taxation treatment will apply if the lump sum death benefit is paid via her deceased mother s estate. The trustee of Alison s mother s super fund will not withhold any tax and the death benefit paid to the estate will be the gross amount of $510,000. The estate withholds $97,025 (excluding the Medicare levy) in tax on the payment made to Alison. How is the taxable component untaxed element calculated? An untaxed element generally arises in death benefits in two situations: where a taxed fund pays out a lump sum death benefit funded by insurance where deductions were claimed for insurance premiums from an untaxed fund, such as a public sector fund. To determine the taxed and untaxed element of a super death benefit for a client like Alison, including the life insurance proceeds, follow these steps: A. Amount of the lump sum death benefit (including any anti-detriment payment) will be $510,000 When a death benefit is paid as a lump sum to a death benefits dependant, the funds will remain tax-free, irrespective of the presence of the untaxed element. However, a non-death benefits dependant beneficiary will pay 30 per cent tax (plus Medicare levy) on any untaxed element and the untaxed element will be calculated on the entire lump sum death benefit held within the deceased member s super account. Important: When a death benefit dependant chooses to receive a death benefit income stream, the untaxed element will not be relevant as it relates only to lump sum death benefits payments. Could you compensate for the additional tax? Often the insurance cover is grossed up when a benefit is to be paid to a non-death benefits dependant. Ensuring a set amount will be paid to the dependant; this could mean a higher insurance premium. With the case study of Alison, the amount of life insurance would need to increase to $645,761 to provide a lump sum death of $510,000 as shown on the next page. B. The reduced death benefit using the formula below will be: Amount of benefit x days in service period (days in service period + days to age 65) C. Reduce the amount in step B by the tax free component. This will form the taxed element in the fund. D. Subtract the element taxed of the reduced death benefit from step C and the tax-free component from the taxable component in step A to determine the untaxed element. $373,161 $373,161 $136, Alison s mother (aged 56 at death and date of birth 23rd March 1958) passed away on 3 December Her service period date was 11 April 1992 and last retirement date at age 65 is 23 March 2023.

19 IOOF TechConnect Technical Insurance Guide The revised components of the case study are outlined in the following table. The effective tax rate remains at per cent whilst the tax payable increases to $135,761. Components and taxation of lump sum death benefit Gross payment Tax rate Tax withheld Net payment Taxable component (taxed element) $472, % $80,334 $392,219 Taxable component (untaxed element) $173, % $55,427 $117,782 Total $645,761 $135,761 $510,000 Important: The gross up life insurance strategy needs to be regularly reviewed to ensure the net lump sum death benefit will continue to be achieved. An adviser will need to assume that a client will die on a set date each year (the review annual date), however assuming the client s super account balance remains constant, the amount of lump sum death benefit taxes will reduce and the net lump sum death benefit will increase. Anti-detriment payments An anti-detriment payment to an eligible beneficiary only occurs at the time a lump sum death benefit is paid. The additional payment is a refund of the fund tax paid on concessional contributions made during the member s lifetime. Where the calculation is by formula the lump sum payment amount used is reduced by any tax free amount and any insurance proceeds. Important: Not all super funds will pay an anti-detriment benefit. Further, whilst they may pay it in accumulation phase they may not pay it for commutations of pensions It is important that an adviser research the fund they intend to recommend. Understanding the intricacies of this area could make a substantial difference to a lump sum death payment. Avoiding unintended super lump sum death benefit tax a need for appropriate pre-death planning When a lump sum death benefit is paid on the death of a super member into an estate, the taxation treatment of the lump sum death benefit will depend upon who will receive the payment. If a non-dependant for tax purposes receives the payment (such as an adult financially independent child), the taxable component will be taxed at 15 per cent (plus Medicare levy). Where the lump sum death benefit includes life insurance proceeds they are added to the taxable component. The taxable component will consist of a taxed element and an untaxed element. If the beneficiary is a super dependent who is a tax dependent the taxable component is treated as non-assessable non-exempt income (tax free). If the beneficiary is not a tax dependent there will be a taxed element and an untaxed element Tip: Maximise the client s service period. The longer the service period of the client s super interest the smaller the untaxed element. When the super passes into a testamentary trust, the ATO will seek to determine whether the beneficiaries of the trust are dependants or non-dependants for tax purposes. If the beneficiaries of the testamentary trust include nondependants for tax purposes, lump sum death benefits tax will apply and potentially the higher tax rate on the taxable component untaxed element if life insurance is involved. An opportunity exists for a solicitor, who is an estate planning specialist, to draft the terms of the testamentary trust deed to avoid this issue. The deed could exclude beneficiaries that are non-dependants for tax purposes from being capital beneficiaries and limit them to being income beneficiaries. The terms for the deed could be complicated and costly. However, the lump sum death benefits tax would far outweigh the cost to do so. Important: To avoid this issue and maintain flexibility for the beneficiaries of the testamentary trust, the life insurance may need to be structured outside of super. The estate would be the intended beneficiary of the insurance policy. 17