Term life insurance inside superannuation

Over the past 2.5 years, the Life Insurance industry has seen an increase in term life insurance (death benefits) being written within superannuation. Due to the elimination of reasonable benefit limits (RBLs) on 1 July 2007, more people have recognised the attractiveness of funding life insurance premiums via superannuation.

Pro's of having term life insurance inside super

Premium affordability is often the key motivator that attracts individuals to place their term insurance via superannuation. Premiums can be paid from existing superannuation savings, non-concessional (undeducted) contributions, salary sacrifice arrangements in the case of employees, or tax-deductible contributions by the self-employed (concessional contributions). This allows term life insurance to be put in place with little if any impact on a member's cash flow. In particular circumstances, the government can also assist with the payment of premiums through various concessions, such as government co-contributions for low-income earners, along with spouse contributions. These incentives are not available when purchasing insurance outside of the superannuation environment. Superannuation fund trustees may claim a tax deduction when they pay life insurance premiums that provide death benefits (ss 295-460 and 295-465 ITAA 1997).

Con's of term life insurance inside super

It should be noted that with concessional contributions being cut in half from 1 July 2009, term insurance inside superannuation is far less attractive. For individuals who are under age 50, the concessional contribution limits are $25,000 per annum, while those individuals aged 50 and over have concessional contribution limits of $50,000.

With the impact of the Global Financial Crisis (GFC) still being felt, many people are focusing their attentions on using their superannuation contributions to rebuild their nest egg. Every dollar that is used to pay for term life insurance inside superannuation is one less dollar that can be used to invest in a concessionally taxed investment environment (taxed at a maximum rate of 15% inside super, versus a maximum rate of 46.5% outside super).

Affordability is just one part of the term life insurance inside super puzzle. Two other issues involve who is entitled to receive the death benefit, and how much of the benefit is eroded due to taxation.

Who is entitled to your death benefit when term life insurance is inside super?

The following individuals are entitled to receive the benefit under the SIS Act: members may nominate in any proportion they deem appropriate their legal personal representative, spouse (legal, de-facto, same-sex), child (stepchild, adopted, ex-nuptial child of any age), part of an interdependency relationship, or any person who is financially dependent at time of death.

The only problem is that if the nomination is not correct, then the trustee of the super fund determines who receives the death benefit. There are three types of nominations. With a non-binding nomination, a trustee may consider a member's nomination, but the trustee still has ultimate discretion. A binding nomination remains in force for three years from date of signing, but it must be witnessed by two independent witnesses and the percentage of benefits paid to the beneficiaries must be clearly specified, if the nomination does not comply, then any payments are subject to trustee discretion. Non-lapsing death benefit nomination is a binding death benefit nomination that does not lapse, remains in force until amended or revoked, but needs to be diligently monitored.

Taxation of death benefits inside super

When a lump sum death benefit is paid from a superannuation fund to the member, it is necessary to understand that there may be a tax liability. The amount of tax depends upon the age of the member, service period start date, and date of death, and who the beneficiary is. It should be noted that taxation dependents are different to superannuation dependants. Under taxation law, children over 18 are non-dependants unless financially dependent or can demonstrate an interdependency relationship.

Example 1
John, 51, is a doctor. He has $500,000 death cover plus $200,000 in asset balance (all taxable component). John dies of a heart attack on 1 August 2009, and his wife, Helen (age 49), lodges a death claim*. She receives a tax free lump sum death benefit of $700,000. This is a great result for the grieving widow.

Example 2
John, 51, is a doctor. He has $500,000 death cover plus $200,000 in asset balance (all taxable component). John dies of a heart attack on 1 August 2009. John's wife predeceased John (he is a widower), and nominated his nondependent son, Frank (aged 26), to receive the entire superannuation payout*. Frank can only receive the death benefits as a lump sum, but how is it taxed?

Calculate the untaxed element
$700,000 x (5,112/12,784) = $279,912.39

$279,912.39 x 31.5% = $88,172.40

Calculate the taxed element
$700,000 - $279,912.39 = $420,087.61

$420,087.61 x 16.5% = $69,314.46

Total tax paid = $69,314.46 + $88,172.40 = $157,486.86

Net death benefit = $700,000 - $157,486.86 = $542,513.14

If the term life insurance premium paid on this policy was $2,000 per annum, and the tax deduction at the highest marginal tax rate was 46.5% (or $930), then the you would have had to pay premiums for over 160 years for the tax savings from the premium payments to be greater than the tax liability when the benefits are paid!

Example 3
Same as above, but John owns a Personal Insurance policy outside superannuation. Whether he nominates his wife, Helen, or his son, Frank (or a combination of the two), the entire death benefit will be paid tax free.

In addition to the taxation benefits, many term life insurance policies provide ancillary benefits that are not available within the superannuation environment. The Advance Payment Benefit pays up to $20,000 to the beneficiary to assist with the cost of funeral and other similar expenses, while the Financial Planning Benefit pays up to $5,000 for approved financial planning advice that is provided to the beneficiary.

Should you have term life insurance inside superannuation?

Although tax deductibility of premiums within superannuation is attractive, it hides a sting in the tail - taxation of death benefits to non-dependants. You should carefully consider all of the advantages and disadvantages when determining if term life insurance is placed inside or outside superannuation.

If you need any additional advice speak to xLife for free Life Insurance Quotes today.

* Note - assumes the your date of birth was 31 July 1958, joined a complying superannuation fund on 31 July 1988 on his 30th birthday, and died on 1 August 2009 (just after his 51st birthday). No non-concessional, undeducted, or non-preserved assets inside the fund.

Source: CommInsure 2010

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June 2010