Each year more than 700,000 Australians receive disability support pensions. This costs Australian taxpayers more than $8.6 billion, according to Centrelink. The more disheartening statistic is that a person who receives this benefit must survive on less than $15,000 per year.
It is vital all advisers ensure their clients obtain adequate insurance coverage. In order to maintain their standard of living over prolonged periods of incapacity, clients need income protection insurance. This cover normally replaces up to 75 per cent of the life insured’s pre-disability income. But what happens to clients who are never able to return to their chosen occupation?
The client is a 35-year-old IT consultant, earning $150,000 per annum with a monthly benefit of $9,375 per month. He was riding his bicycle and was involved in an accident with a four-wheel drive vehicle. The client experienced serious injuries, including quadriplegia. He purchased income protection insurance just six months prior to the accident.
Option 1: Normal monthly benefits
The most obvious response in this situation is for the client to continue receiving the regular monthly income payment through to the policy termination age (in this case age 65). The client would continue to submit regular medical and claim forms, usually on a monthly or quarterly basis.
The benefits would be taxed at the client’s normal marginal tax rate. The gross annual benefit payment would be $112,500 ($9,375 x 12), while the net benefit after tax is $79,812.50 per annum.
Option 2: Ex gratia lump sum payment
In some cases, the life insurance company may offer a lump sum ‘commuted value’ payment in lieu of making payments through to age 65.
This is normally an ex gratia offer at the discretion of the life insurance company.
While this lump sum benefit could be a useful windfall for the life insured, there is no certainty for the client.
The entire lump sum benefit is also taxed as income in the year of receipt up to 46.5 per cent (Sommer v FC of T) – a very nasty sting in the tail.
Based on actuarial calculations, let’s assume the client receives 15 times the annual benefit of $112,500 ($9,375 x 12). The gross annual benefit payment would be $1,687,500, but the net amount after tax would only be $723,200.
Option 3: TPD rider in income protection
The final option is a lump sum payment on total and permanent disablement (TPD) instead of a monthly income protection benefit. This special TPD rider benefit within an income protection policy is only provided by two insurance companies in Australia.
Taxation ruling CR 2005/15 allows the client who was totally and permanently disabled (own occupation) and receiving income protection payments a choice in this type of situation; they could either continue to receive a taxable monthly benefit or they could receive a tax-free lump sum benefit.
There is, however, one small condition imposed by the Australian Taxation Office: the premium will not be totally tax deductible as in Option 1 or Option 2, but only 90 per cent tax deductible. This means if a client were paying a premium of $1,000 per annum, only $900 would be tax deductible if they chose this option at the time of policy application.
Under this option, as the client is under age 40, the lump sum benefit is 15 times the annual benefit of $112,500 ($9,375 x 12). The gross annual benefit amount and net benefit would be $1,687,500 (no tax).
Let’s consider the long-term situation of the client.
The lump sum, if invested, would need to earn between 2.78 per cent (assuming consumer price index [CPI] of 0 per cent) and 6.6 per cent (assuming CPI of 3 per cent) to generate the same income stream through to age 65 as in Option 1.
What was the outcome?
The client selected the tax-free lump sum (Option 3). It allowed the client to have a choice. He spent the payment on medical expenses, carers, rehabilitation, equipment and paying off debt, while investing any excess proceeds. The lump sum also allowed his wife to leave her job (also an IT consultant) to care for him.
Any of the three options may be appropriate in this type of situation. A qualified financial adviser can assist clients in determining the best option for them at claim time.
Jeffrey Scott is executive manager, business growth services, CommInsure.