How is life insurance taxed in Superannuation?
Life Insurance in superannuation is pretty common and is normally offered automatically when you join. So although people tend to forget they have it or don’t know they have life insurance in superannuation, most people will have some level of cover. In fact since 2008 it has been mandatory for employer sponsored superannuation funds to offer a minimum standard level of Life Insurance in superannuation of up to $50,000.
There are however big difference’s in the way that life insurance policies are taxed when they are in a superannuation fund. Unlike personally owned life insurance policies that are not taxed when a claim is made (unless it is a policy for business purposes), superannuation policies are. When taking out, reviewing or considering life insurance in superannuation a person needs to keep this possible tax in mind otherwise your family may be short at claim!
There are obviously attractions of putting your life insurance in superannuation or an SMSF, like tax deductible premiums. But don’t forget what the government gives you now they probably want back later! By owning life insurance in superannuation, the taxation on claims becomes a little more complex and a few extra conditions need to be met when claims are made.
A superannuation fund can only pay a claim to a narrow scope of people including legal representatives (your estate), children (including step-children, ex-nuptial and adopted), spouses (including de-facto and same sex) and can include ex-spouses. When a claim is paid these people they are either deemed to be; financially dependent (a Taxation Dependent) or a non-dependent (if it is paid to the estate then the person who eventually gets paid it is assessed)
If your beneficiary is classed as ‘financially dependent’ then life insurance proceeds paid from superannuation are paid tax-free. Some beneficiaries are automatically classed as ‘taxation dependents’ and these include current spouses and children under the age of 18. That is the easy part.
A person who isn’t automatically classed as a dependent can apply to be assessed as one (and have no tax payable on the life insurance claim) if they can establish what is called an ‘interdependency relationship’ under s302-200 of the Income Tax Assessment Act 1997. Any beneficiary can apply for this but to have proceeds paid tax-free ‘intedependency’ must be established and in some circumstances it can be somewhat difficult. In order to establish the relationship, the following must exist;
- they have a close personal relationship, and
- they live together, even if they are not related by family, and
- one or each of them provides the other with financial and domestic support and personal care.
If you cannot convince the ATO or the superannuation fund that an ‘interdependency relationship’ exists then a tax bill won’t be too far behind. This is most common with adult children. It is the life insurance claims paid from superannuation to non-dependents where the tax gets complicated.
Everybody’s superannuation balances are made up of different ‘elements’ and ‘components’ that attract different rates of tax. As these elements and components cannot be altered or changed at claim we won’t discuss how they come about (in an attempt not to complicate it even further!). When a life insurance claim is made from superannuation, the claim will be added to the existing balance and split in the different tax categories that already exist in the superannuation fund. Those are;
What does this mean? Say for example a person has $100,000 in contributions in their superannuation fund with $10,000 tax-free (10%) and $90,000 taxable (90%). When a life insurance claim is made, the life insurance claim is added to the contributions and is split in the same percentage. In this case 10% of the total will be ‘tax-free’ and 90% will be taxable.
Calculating the taxation liability can be somewhat difficult as the ‘taxed element of the taxable component’ is taxed at 16.5% (including Medicare Levy) and the ‘untaxed element of the taxable component’ is taxed at 31.5% (including Medicare Levy). Furthermore the percentages that everything gets split up between depends on when the member entered the fund and the time until the member would have retired.
Take this scenario as an example;
Andrew aged 50 suddenly dies of a heart attack on the 1st February 2012. Over his lifetime he has accumulated $300,000 in superannuation assets and was insured for $600,000. Andrew nominated his 22 year old son to receive his entire benefit who is no longer dependant. Andrews son is working part-time, studying at university and lives with friends.
Although the gross amount of benefits left to Andrews son is $900,000, he would receive the following amount after accounting for taxation;
|Work out the tax on the ‘untaxed element of the taxable component’|
|Total Sum x (days from death until notional retirement divided by days from joining fund until notional retirement)|
|$900,000 x (5,164 / 13,384) = $347,250|
|$347,250 x 31.5% tax = $109,383 tax on ‘untaxed element of the taxable component’|
|Work out the tax on the ‘taxed element of the taxable component’|
|Total Amount – Untaxed Element Amount|
|$900,000 – $347,250 = $552,750|
|$552,750 x 16.5% = $91,203 tax on ‘taxed element of the taxable component’|
|Total taxation payable = $109,383 + $91,203 = $200,586|
|Net life insurance from superannuation claim payment = $900,000 – $200,586 = $699,414|
*Andrew’s entire balance was comprised of a ‘taxable component.’ He was born 22nd March 1961, joined the fund on the 31st July 1989 and died on the 1st February 2012. The number of days from fund start date to notional retirement is 13,384 days and the number of days from death until national retirement is 5,164 days.
From the example above, Andrew’s son in this scenario would have incurred a taxation liability of $200,586 and would have received a net amount of $699,414. If Andrew did not think or know about this future tax liability or communicate this to his family, then Andrew’s son could be left with a shortfall if the total amount paid did not cover the financial need.
A common question asked regarding superannuation benefits and taxation is what happens if the proceeds are left to the estate? In this case the liability for taxation depends on who ultimately receives the benefits. If they are classed as a ‘taxation dependent’ then no tax will be payable, otherwise if the definition cannot be met, then the end-beneficiary will be liable for taxation.
It is important to consider the taxation implications of life insurance in superannuation. Although premiums look attractive as they can be paid ‘pre-tax,’ consideration needs to be given to the added complexities of life insurance claim payouts and taxation under superannuation.
Have questions about life insurance in superannuation or how it can be taxed or are you about to receive a claim and want to receive some help? Start your journey to becoming your own MoneyGeek and start a conversation below.
About the Author – Benjamin Irons
Benjamin has been involved in the financial services industry since 2004. Benjamin has a Bachelor in Business, Diploma of Financial Services (Financial Planning). Previously a Financial Adviser and a business owner, Benjamin has worked with hundreds of individuals and businesses to implement simple strategies to improve wealth. Benjamin writes for a number of websites to assist people take control of their finances and find their financial freedom!