Should you have income protection insurance?

SMSF technical expert and columnist for The Australian newspaper
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Many SMSF trustees get confused about what type of income protection insurance they should buy, and how that insurance works within their self-managed super fund.

The confusion became evident recently when I was asked about it on Peter Switzer’s Super Show on 2GB, so today, I’m going to run over some of the key things you should know about this type of insurance.

Income protection insurance, as the name suggests, is a life insurance contract that pays you an ‘income’ if you if you can’t work due to illness or injury. Depending on your insurer, you might find this product also referred to as salary continuance insurance.

It pays a monthly benefit, which often represents a fixed percentage of your normal income. Most insurers allow you to select different payment periods for illness or injury benefits. For example, you might want an illness benefit to be paid for only two years, but the injury benefit to be paid for five years.

There are a few reasons to purchase this insurance in your SMSF other than to protect your personal cash flow. For example, you might want to use your compulsory super contributions to pay the insurance premiums.

These premiums are tax deductible in an SMSF as long as the life policy covers your temporary inability to perform your normal employment duties. This means that if you’re not employed, then these insurance premiums aren’t deductible.

Another limitation relates to beneficiaries. Most life insurance policies allow you to nominate a policy beneficiary, however, you can’t take advantage of this option when you buy the insurance using your SMSF.

When income protection insurance is taken out inside super, the super fund trustee is the policy owner and a super fund member will be the life insured. For many years it was thought that a super fund could only purchase income insurance that provided two years of illness and injury benefits, although thankfully this restriction has long since gone.

In Australia, there are typically three different types of definitions of ‘disability’ that a policyholder must satisfy if they plan to make a claim: any occupation, similar occupation and own occupation. Carefully check how your insurance policy has defined your occupation. For example, own occupation will pay out a benefit if you are unable to do your own occupation due to illness or injury, and so forth (read, New rules means it’s time to check your insurance policy).

Another key issue you should check is that you’re eligible to receive the insurance benefit if you make a claim – sometimes the benefits can get locked up in the super fund, meaning you can’t access them until you retire.

So you need to make sure the insurance policy matches when a benefit can be paid out under your trust deed and under the super laws. Many older SMSF trust deeds don’t allow an income protection benefit to be paid, which means you would likely want to have a new one drawn up.

When an insured person stops work because of a non-permanent mental or physical illness, this is referred to as ‘temporary incapacity’.

A super fund must pay temporary incapacity benefits as an income stream, and the income paid can’t be greater than the income before disablement. This means that if you return to work on a part-time basis, then the temporary incapacity income must be reduced to ensure that your income doesn’t exceed your pre-disablement remuneration.

It’s also important to know that the benefit paid to a member can’t include the member’s minimum benefit (which in most cases, is the SMSF’s account balance).

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

Also in the Switzer Super Report

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