Individual circumstances dictate whether income protection cover is held inside or outside of superannuation, or whether split ownership is appropriate.

Working Australians have a one-in-three chance of becoming disabled for more than three months before retirement age (Actuaries Australia, 2000); and $1.2 billion+ in income protection claims were processed nationwide in 2013. These statistics not only underline the importance of protecting your income stream, they highlight the security income protection can provide.

When considering the best policy it is important to evaluate your individual circumstances to determine whether your income protection should be held inside or outside of superannuation. There are complex differences to both structures and the decision-making process can be challenging to navigate without sound financial advice.

Weighing up your options

Regardless of whether income protection is held inside or outside superannuation, some key features remain the same:

  • Both structures can offer tax deductibility.
  • Recipients are taxed at marginal rates on receipt of benefits.
  • After-tax cost of income protection cover is the same.

The primary advantage to a policy within superannuation is there is no impact on day-to-day cash flow. You can use the 9.5% superannuation guarantee contribution or accumulated superannuation balances to finance the cost of your cover.

However, purchasing income protection insurance through superannuation can present significant disadvantages. A key shortcoming is superannuation contributions funding income protection cover are included in the concessional contribution cap, which is set at $30,000 per year or $35,000 per year if aged over 49. Insurance in superannuation can erode this cap leading to potentially serious consequences, particularly for older people.

Additionally, the Trustee must comply with the trust deed and Superannuation Industry Supervision (SIS) Act (1993) requirements where income protection is held through superannuation, generating a greater compliance burden.

Requirements of the temporary incapacity condition of release must also be met before the income protection benefit can be paid whereas, outside superannuation, the insured person only has to comply with the terms of the insurance contract.

Another factor to consider is that insurance benefits paid through super cannot be paid as a lump sum; rather they are paid in substitution for the income the member was receiving before incapacity. This means certain ancillary benefits such as the childcare benefit or needle stick injury benefit cannot be offered by a traditional superannuation fund, and are particularly problematic within a self-managed super fund (SMSF), with the risk of any benefits being locked in the SMSF.
The receipt of total and permanent disability (TPD) benefits outside of superannuation in conjunction with income protection benefits within superannuation may also create difficulties. TPD benefits are paid on permanent incapacity, while income protection benefits are payable on temporary incapacity only. The concepts of permanent and temporary incapacity are mutually exclusive – a member is either permanently or temporarily incapacitated, they can’t be both.

If the agreed value contract of the policy resulted in entitlements greater than pre-disability income, any excess would be retained by the super fund, presenting difficulty for those with fluctuating incomes.

A third option

An alternate structure allows you to hold a portion of the income protection inside superannuation and a portion outside. There are several benefits to this structure, including:

  • The impact on day-to-day cash flow is reduced substantially as the super fund will pay majority of premiums with a smaller portion deducted from cash flow.
  • The cover is more comprehensive than an income protection policy solely inside super. It provides greater certainty in the event of a claim as benefits that don’t comply with the SIS Act are held outside superannuation.

Making the right choice

Selecting an appropriate income protection insurance structure is dependent on the unique circumstances of each individual.

For those with sufficient cash flow or close to the peak of their earning capacity, and ‘empty nesters’ – whose priority should be contributing the maximum amount to super – income protection outside superannuation is likely the better option.

Meanwhile, people with uncertain cash flow (such as those starting a business), or younger families with plenty of working years ahead but tight finances at present, might be better off insuring their incomes through the split ownership option described above.

Those for whom a ‘vanilla’ product without added certainty would suffice might find insurance through superannuation easier and more efficient.

Seeking expert advice

When researching income protection options, seek advice from a qualified financial planner who will not only establish the best fit for your requirements, but will evaluate your cover annually to ensure you still have the optimal structure as your circumstances fluctuate.

If you would like more information please call 1300 ELSTON or email info@elston.com.au and an adviser will be in touch.