Insurance is an essential component of any successful wealth building strategy and more importantly it ensures that you and your family will be looked after in the event of serious illness, accident or death.
1. Types of insurance available
– Life cover can help your family cope financially in the event of your death.
– Total and permanent disability (TPD) cover provides a level of financial security to and your family if you are unable to work due to long term illness or injury.
– Trauma cover will provide you with funds to assist in meeting medical and other costs that can arise should you suffer a specific trauma.
– Income protection cover will provide you with regular income should you be unable to work temporarily because of illness or injury.
Chances are you have heard about the above types of insurances and you may even have some of the above policies yourself – which is great.
The key thing we need to do is ensure that the policies are held in such a way that you and your family are looked after in the most tax effective way possible.
2. Tax deductibility
The following table compares the above insurance and compares the tax deductibility of policies owned in your personal name and by an SMSF and provides a recommendation in regards to who should own the policy:
Deductible in your own name?
Deductible in name of SMSF?
Who should own the policy?
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Income protection insurance
*It is possible to hold income protection insurance policies in the name of a SMSF, however due to a person’s marginal tax rates typically being higher than the 15% tax paid within a SMSF it is more tax effective to hold the policy in an individual’s name.
As you can see by the above table, the only way to obtain a tax deduction for the payment of life and TPD insurance premiums is to hold them via a superannuation fund such as a SMSF.
3. Why insurance is so important with property investments (and debt)
With the advent of SMSFs being able to borrow to invest in residential and commercial property via an installment warrant structure, there is an increased need for insurance due to a large percentage of the SMSFs assets being tied up in one single investment – i.e. there is lack of liquidity.
This lack of liquidity will become a huge problem if one of the members becomes disabled, dies or is unable to work for an extended period of time.
The following case study demonstrates how important it is to have correct insurances:
* Husband and wife in their late thirties with a combined before tax income of $120k (husband $75k / wife $45k)
* SMSF Assets:
– Cash $20,000
– Property (via installment warrant / debt trust) $300,000
– Loan ($200,000)
– Net SMSF Assets $120,000
* The net assets (or member balances) are split approximately husband $80k / wife $40k
* The net cash flow generated from the investment property before annual administration costs is around $4,000 per annum
* The SMSF holds no insurance policies
Now, let’s assume that the husband becomes permanently disabled and it no longer able to work. In this situation he would have met a ‘condition of release’ meaning he can access 100% of his superannuation balance as either a lump sum or have it drip feed via a pension.
If he decides to take a pension to make up for his lost employment income of $75k per year, the SMSF is going to quickly run into liquidity problems as the only cash it will be receiving is the $4,000 per year from the property (after expenses such as interest and rates) and $3,442 from his wife’s 9% super contributions ($45k x 9% = $4,050 less 15% tax).
For the SMSF to continue funding a pension or for the husband to take his $80k of benefits as a lump sum they would need to sell the property and pay back the loan. This is not ideal because they would not be selling the property on their terms – they have to take whatever price they can get for a quick sale.
This may mean the property that is ‘worth’ $300k might only be able to be sold with proceeds of $270k, which after paying out the loan would leave the SMSF with no more than $90k is cash – up to $80k of which can be paid out to the husband with the wife’s benefit making up the rest* ($10k).
If the family requires $1,200 per week after tax to pay the mortgage, car payments, school fees and other household bills – that $80,000 is not going to last any more than 4 – 5 years assuming the wife is able to still work and earn the same amount.
*A SMSF has the flexibility to allocate profits and losses from investments disproportionately.
4. Hints and tips
Now we have established the need to have appropriate insurances – both inside and outside a SMSF, we need to ensure the insurances are able to be held by the SMSF.
– Trust deed
The trust deed of the SMSF needs to be reviewed to ensure that is can hold both life and TPD policies on behalf of its members. The vast majority of SMSF trust deeds currently available in the market of course do allow insurance policies to be held – however some old deeds that are floating about do not.
If you already have a SMSF you need to double check your deed – even if you already have insurance policies in the name of the fund. Chances are your insurance adviser / insurance company did not check your trust deed before arranging the policy (ies).
– Trustee minutes & reserves
By default, when an insurance company pays a benefit under a life or TPD policy, they have to pay it into the members account within the SMSF (i.e. the monies will be deposited into the SMSFs bank account however on paper the proceeds are allocated to the member to whom the policy and payout related).
This scenario is OK most of the time, such as in a situation similar to the case study mentioned above – as the insurance monies would go into the husband’s name and then be used to pay for a pension or lump sum to supplement the family’s income needs.
However – this is not always in the best interests of the members.
Sometimes it may be beneficial for some of all of the insurance proceeds to be used for other purposes or treated differently rather than simply being lumped on top of the members (or deceased members) account within the SMSF.
These reasons may include:
* The member or their estate may be bankrupt (some or all of the proceeds paid out may be taken by the trustee in bankruptcy)
* Proceeds to be kept within the SMSF rather than having to be paid out as a lump sum (i.e. when the only beneficiaries are ‘non-financial dependents’ such as adult children who have to have the amounts paid out to them as a lump sum rather than a pension)
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