Life insurance policies held within superannuation provide two main benefits. They allow premiums for the insurance policy to be tax deductible and they allow these premiums to be paid by from a person's superannuation member balance, rather than from their cash flow. This can be beneficial compared to if the policy is owned in an individual's name where the premium is paid from their after-tax cash flow.
If a life insurance policy is owned within superannuation, it is important to understand how the proceeds are treated when paid out to ensure that the intended beneficiary actually receives the proceeds and how the proceeds will be treated from a tax perspective.
When a person who holds a life insurance policy within superannuation passes away the proceeds will be paid into their member account, which will form part of the overall death benefit. So it is important to have measures in place, such as a superannuation nomination, that will direct the trustee to pay the member balance (including the insurance proceeds) to the intended beneficiary. Without a nomination, the trustee has discretion as to who the proceeds are paid to having regard to all of the individual's dependants. If a superannuation nomination or the trustee determines that the proceeds are to be paid to the estate, then it will form part of the individual's overall estate and be distributed via the Will.
The tax payable on the superannuation death benefit will be determined by the recipient of benefit. An ordinary member account (excluding insurance proceeds) will generally include a 'taxable - taxed' component and a 'tax-exempt' component. The 'tax exempt' component will be received by the recipient of a death benefit tax free, regardless of who they are, whereas a 'taxable- taxed' component will only be received tax free by certain recipients, including a spouse, a child of the deceased under 18, a person who financially dependant on the deceased or a person who had an inter-dependancy relationship with the deceased just prior to their death. These people are referred to as 'tax dependants'. Tax of 15% will be payable if the death benefit is not paid to one of these people.
When insurance proceeds are added into the mix, the insurance component of the death benefit will usually be 'taxable – untaxed'. This is due to the fact that a tax deduction was claimed for the premium. A 'taxable-untaxed' component will also be received tax-free by a tax dependant if the death benefit is paid as a lump sum, however will be taxed at up to 30% if received by a non-tax dependant (such as a child of the deceased over 18).
A tax-dependant is also able to receive the superannuation death benefit as a pension. In this situation, both the 'tax-exempt' and 'taxable-taxed' portion of the pension will be received tax free by the recipient if either they, or the deceased, are over age 60. If both are below aged 60, the taxable component of the pension will be taxed will be taxed at the recipients marginal tax rate (MTR) – with a rebate of 15% of the 'taxable-taxed' portion of the pension payment.
Where the death benefit pension includes a 'taxable – untaxed' component, this portion of the pension will be taxed at the recipients marginal tax rate, less a 10% offset, if either are over age 60. No offset will be available if both are under age 60.
If a super death benefit is paid to an estate it will be distributed via the Will. Tax will be paid proportionately based on the components involved and the recipients.
It is not possible in any instance to segregate the tax components of a superannuation death benefit so that it can be distributed in a more tax effective manner.
All of this information needs to be taken into account when owning life insurance in superannuation and may affect the level of cover required. For example, if a life insurance policy was held within super by an individual for the benefit of their spouse, the calculation of the level of cover is simple – it is what it is. However, if a specific amount of cover was intended for the adult children of an individual, the level of cover would need to be grossed up to account for tax ('taxable-untaxed' component is taxed at up to 30%).
Intended level of cover / 70% = actual level of cover required.
So, if a parent wanted to provide their adult child with a sum of $1,000,000 upon their death, to allow their child to eliminate all debt on the family properties, approximately $1,430,000 ($1,000,000/70%) of cover would be required to ensure a net benefit of $1,000,000.
Marginal tax rates should also be considered when determining the level of cover where a spouse intends on receiving any insurance proceeds as a pension from superannuation, remembering that income from an untaxed source (insurance proceeds) are taxed at their marginal tax rates.