November 17, 2010

Utilising insurance cover within your SMSF

By Kris Kitto

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.

Often when investors establish a SMSF they overlook the need for insurance cover and can lose any existing cover they had within an industry or retail super fund and are unable to obtain replacement insurance cover within their SMSF.

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.

Tax deductibility

The following table reviews the above insurances 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:

Insurance TypeDeductible in your own name?Deductible in name of SMSF?Who should own the policy?
Life insuranceNoYesSMSF
TPD insuranceNoYesSMSF
Trauma insuranceNoNoOwn name
Income protection insuranceYesNoOwn name*

*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.

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 instalment 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:

Case study

  • 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 instalment warrant / debt trust)             $300,000

–          Limited Recourse 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.

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)
  • To populate a Section 279D reserve with funds to enable a potentially massive tax deductible payment to be made
  • Overall flexibility of planning for tax effectiveness of payments

Some trust deeds enable insurance proceeds to be put into a reserve, however the trustee of the SMSF must execute a minute before the insurance proceeds payment becomes payable (i.e. before a member dies or becomes disabled) to give the trustee the option to allocate some or all of the insurance proceeds to a reserve.

What is a reserve account anyway?

There are some fantastic strategies available the utilise reserves within SMSFs – the topic of reserves deserve a dedicated post all by themselves, so I will not go into too much detail here.

They key thing to note is that a reserve within a SMSF doesn’t ‘vest’ or belong to any particular member within the SMSF, and can be illustrated as follows:

–       Self insurance

It is possible to self-insure to ensure that the situations such as the one mentioned in the case study do not occur.

However, self insurance normally requires there to be access to other assets or sources of income that may not be available to you if you are still in the process of building wealth to fund your lifestyle and retirement.

If you do have significant assets within your SMSF, you are able to populate a self-insurance reserve account within your SMSF utilising the earnings and capital growth from your SMSF investments – and you can even obtain an annual tax deduction for your SMSF for the equivalent ‘premiums’ (this needs to be worked out by an actuary).

What to do now

Whether you already have a SMSF or are looking to establish one shortly, it is essential that you get your insurance needs assessed and have your SMSF acquire appropriate insurance policies on behalf of the members.

Although you can shop around by yourself for a policy you may thinks suits the needs of yourself and your family, you are better seeking advice from an experienced insurance adviser.  It will cost you nothing are you are more likely to get better cover at a better price compared to if you organised it yourself.

If you have any questions feel free to leave a comment or email me.