Home | Databases | WorldLII | Search | Feedback Precedent (Australian Lawyers Alliance)

Reynolds, Andy --- "The Tax and Financial Implications Following Approval of Superannuation Insurance Settlements" [2023] PrecedentAULA 52; (2023) 178 Precedent 16

The tax and financial implications following approval of superannuation insurance settlements

By Andy Reynolds

Approved personal insurance claims differ significantly from other types of personal injury common law settlements, particularly superannuation total and permanent disability (TPD) insurance settlements. Following a successful superannuation TPD insurance settlement, the claimant will need to submit a withdrawal form to their super fund. The withdrawal will generally be taxable at a different rate for everyone and could trigger a range of financial implications.

What do super insurance claimants need to know after their claim has been approved?

PERSONAL INSURANCES

There are four types of personal insurances: total and permanent disability (TPD), death (or life) cover, income protection and trauma (or critical illness) cover.

TPD, death and income protection can all be held within superannuation or directly with the insurer. Trauma cover cannot be held through super. Most Australians have automatic TPD and death cover through their super fund. As death cover claims are relatively straightforward, the main type of claims that personal injury law firms assist their clients with are super TPD claims.

Holding personal insurances through super allows many Australians to have injury insurance cover that they otherwise wouldn’t be able to afford. There are tax and cash flow benefits to holding the cover through super, however, there are tax and other financial considerations on approval of those claims.

SUPERANNATION TPD CLAIMS

When an insurer approves a superannuation TPD claim, the sum insured amount is paid into the member’s superannuation account and added to their existing superannuation balance.

The superannuation trustee then determines whether the member meets the ‘permanent incapacity’ condition of release (as described in sub-s10(1) of the Superannuation Industry (Supervision) Act 1993 (Cth) (SIS Act)). Once the trustee confirms this requirement is met, the member’s superannuation and TPD balance becomes fully accessible, allowing the member to withdraw a portion or all of their super and TPD funds, and/or commence a superannuation income stream.

SUPER TPD CLAIMS AND TAX

The superannuation trustee needs to confirm that their member meets the permanent incapacity condition and then determine whether the member is entitled to withdraw their benefit as a ‘disability superannuation benefit’ and therefore entitled to the TPD tax concessions (as described in sub-div 307-145 of the Income Tax Assessment Act 1997 (Cth)). This definition is the same as the SIS Act’s ‘permanent incapacity’ definition, but specifically requires two medical doctors to also certify that the member meets this condition.

The superannuation lump sum withdrawal tax rate is 22 per cent (including 2 per cent Medicare levy) for Australians under preservation age (currently 59 but soon to be 60 for everyone). Super withdrawals after age 60 are tax free^[1] (except for certain rare government ‘untaxed’ superannuation schemes such as West State by Western Australia’s Government Employees Superannuation Board (GESB) and Super SA).

If the super trustee agrees to permanent incapacity, but the member is not able to have two doctors certify this condition, then the member will pay the full 22 per cent tax rate (if under preservation age).

Assuming the member qualifies for the disability super benefit tax treatment, a portion of their withdrawal will be ‘tax-free’ and they will only pay the 22 per cent tax rate on the reduced taxable portion. The formula for the tax-free amount is: The existing tax-free component + super benefit payment x days to retirement / total service days.^[2]

The member’s ‘future service period’ is tax-free (that is the portion from when they became permanently incapacitated to when they turn 65), as a proportion of their ‘total service period’ (days from their superannuation ‘eligible service date’ to age 65). Every super account will have an eligible service date, which is always the earlier date of the following:

• when the account was set up; or

• when the member commenced employment with the employer that set up the super account for them.

If two super accounts are consolidated, the earlier eligible service date is always retained.

If an Australian has multiple super accounts with TPD cover that is approved, they can have a completely different tax treatment on each super TPD settlement.

Australians going through the TPD claim process should never consolidate super accounts without understanding the tax implications, as this can significantly increase the tax amount they will pay.

DIFFERENCES BETWEEN SUPER FUND PROCESSES

Superannuation funds have different processes following a successful TPD claim. Some will provide withdrawal tax estimates. Some will allocate these funds directly into their member’s default investment option. Some will place them into a cash option. Some will lock in the TPD tax-free uplift. However, most will require updated medical certificates every 12 months to continue to provide the member with the TPD concessional tax treatment.

When COVID-19 hit financial markets in March 2020, it was a wake-up call for many superannuation funds and triggered them to review their processes following approval of a successful TPD claim. Before March 2020, roughly 50 per cent of Australian super funds were automatically investing members’ TPD proceeds into the default investment option, typically a ‘balanced’ or ‘growth’ option. Many claimants who had a TPD claim approved early in 2020 had no idea that these proceeds were going to be paid into their super account and automatically invested, then during March 2020 the average Australian super investment option fell over 25 per cent, which meant claimants’ TPD settlements also fell by this amount.

Many super funds compensated members for the loss due to poor processes following approved TPD claims. Since then, roughly 90 per cent of super funds place TPD proceeds into a cash option (either indefinitely or for a period of time) and let the member decide whether or not they wanted to switch the funds into an investment option.^[3]

TPD CLAIMS, CENTRELINK AND FINANCIAL IMPLICATIONS

After tax-related questions, Centrelink implication queries are common among TPD claimants following the approval of their claim and before making their withdrawal decision. Many TPD claimants are on some type of Centrelink benefit, such as JobSeeker (probably with a medical exemption), disability support pension (DSP), carer and family payments. When a TPD claim is approved and the funds are directed into superannuation, there is no change in or impact to Centrelink payments or any other benefits at this point.

Superannuation is excluded from Centrelink’s means testing until a person reaches 67, their pension age. When the claimant goes to complete their withdrawal form to access funds and to pay their legal bill, this can trigger a range of Centrelink and other financial implications.^[4]

For pensions and allowances, that is JobSeeker, DSP, and carer and parenting payments, Centrelink has an income and an asset position for every person or family receiving these types of payments. Centrelink then applies an ‘Income Test’ and an ‘Assets Test’ to the lower payment.^[5]

Centrelink does not assess the TPD claim or the withdrawal; they look at what the person does with their funds and how much is left over after paying bills, debts and other expenses.^[6]

If a TPD claimant were to make a withdrawal and the entire amount was used to pay their legal bill and other debts and expenses, there would be no change to their Centrelink pension or allowance. If they had a significant amount of money left over sitting in a bank account (including a mortgage offset account), this amount of money would be included in the person’s Centrelink balance sheet. This amount would be included in the assets test assessment and the ‘deemed income’ would be included in their Centrelink income test assessment.

However, if a person or a couple has minimal or no other income, they can have a significant amount of money in the bank (usually over $200,000) before their Centrelink pension or allowance is affected. The actual amount will depend on several factors including whether they are single, have a partner, own a home and their broader financial situation.

Workers compensation payments can also be affected by withdrawing superannuation funds after a TPD claim. For state-based workers compensation payments, in all states except Victoria, the claimant can make a full withdrawal or commence a super income stream with no impact on their work cover payments. In Victoria, claimants can generally access their TPD funds but this can have a significant impact on their WorkCover payments if they access their existing super and/or commence a super income stream. For TPD claimants on the federal Comcare scheme, the implications to workers compensation payments when accessing TPD proceeds are complicated and members need to be careful not to have a significant impact on Comcare payments.

IMPLICATIONS OF ADDITIONAL TAXABLE INCOME

Even though, for many super TPD claimants, the payments may have no impact on their Centrelink pension or allowance, there are a range of other payments that can have an impact on the withdrawal, due to additional taxable income.

As per the formula above, when a superannuation TPD claimant is under age 60 and makes a withdrawal, there will be a tax-free portion and a taxable portion. The taxable portion is included in the claimant’s ‘adjusted taxable income’, which can then have an impact on a range of payments or trigger a penalty. These include:

• Family Tax Benefits Parts A and B.

• Child Care Subsidy.

• Child support arrangements.

• Repayment of HECS or HELP education debts.

• The payment of Medicare levy.

• Some government/community housing eligibility and means testing.

• Div 293: additional super contributions tax.

These implications are usually triggered at the end of the tax year, when the relevant government agency receives the taxable income for the prior financial year, and can trigger repayments or can have an impact on the following financial year.

UNIQUE TPD FINANCIAL STRATEGIES

Superannuation TPD claimants are often confused and unsure of their options following the approval of their claim. Although most claimants will need to make a withdrawal to pay their legal bill and fund other urgent expenses, they do not need to rush into making a full withdrawal of their super and TPD balance. Often there are financial strategies that can significantly reduce the tax the claimant will pay and minimise the impact on any other benefits they are receiving.

Please understand this information should not be considered financial advice. Every individual’s situation is different, and different super funds will have different processes that will have an impact on the applicability of these financial strategies.

After a super TPD claim, the member’s full super and TPD balance will (or should) become fully ‘unrestricted, non-preserved’ and this will never change so the person will have access to their super balance at any time in future and can make further withdrawals whenever they need to. However, the caveat here is that while the person leaves money in the current superannuation fund, they are relying on that super fund to apply the TPD tax-free uplift concession on any future withdrawals. The reason the tax-free uplift is not applied to the existing super and TPD balance is because no ‘superannuation disability benefit payment’ has been made. Also, most super funds will require the two updated medical certificates every 12 months to continue to apply the TPD tax-free concession.^[7]

Below are some examples of unique TPD and personal injury financial strategies.

Rollover strategy

One common financial strategy is that a person may rollover their super/TPD balance to another super fund to ‘lock-in’ the TPD tax-free uplift. No tax is withheld on a rollover. The rollover itself triggers the ‘disability super benefit’ tax treatment outlined above, which means the existing super fund will calculate and crystalise the TPD tax-free amount on rollover to the new super fund. This means the claimant will not need to provide updated medical certificates in future to get this tax-free uplift.

If the person has multiple super accounts, they may rollover and ‘segregate’ their super accounts to retain the more effective tax treatment on certain super accounts and plan to draw from these super accounts before 60, and the more taxable accounts after 60 when withdrawals become tax free.

Superannuation income streams

Most Australians will turn their super account into a super income stream account (also called an account-based pension) when they turn 60 and retire, which is how they will fund their retirement. TPD claimants can do the same thing, however, as they are under 60, they will pay tax on the income they draw – but the tax treatment is very different to lump sum withdrawals, as outlined above. The claimant can optimise this income stream, usually by rolling over first and taking other steps, and then may be able to draw significantly from their super income stream account and pay no tax.

For example, a 45-year-old with average tax treatment and no other taxable income, could withdraw a lump sum of $120,000 and pay over $12,000 in tax. However, they could withdraw this amount as a super income payment (either as a lump sum income payment or an ongoing monthly payment) and pay no tax.

Another significant benefit of commencing a super income stream is there is no earnings tax. All superannuation accounts pay tax on earnings of 15 per cent, internally. Superannuation members do not see this tax; it is paid out of the super fund’s investment returns. But super income streams have a zero tax rate on earnings – so the returns are higher.

Claimants on Centrelink need to consider this before commencing an income stream as the funds in this type of account become assessable under Centrelink’s means testing.^[8]

TPD tax wash-out strategy

This is a more sophisticated financial strategy and is only possible for claimants who have other savings or settlements that they can contribute to super. If a person makes an after-tax super contribution (also called a non-concessional super contribution) into their account before rolling over to another super fund, this contribution will increase the power of the tax-free uplift calculation. The reason for this is the TPD tax-free uplift calculation ‘adds back’ to the existing tax-free component.

Some claimants have enough funds in savings to ‘wash-out’ the taxable component entirely, so on rollover their superannuation becomes 100 per cent tax free, which means any future lump sum withdrawals or income payments will be fully tax free. In addition, this removes the implications of additional taxable income as outlined above.

90-day rule for personal injury settlements

As superannuation laws have changed, there has continually been legislated carve outs for common law personal injury settlements. Where most Australians are capped on how much they can contribute to super and again on how much they can rollover into a superannuation income stream, common law personal injury recipients can contribute an unlimited amount into super and into a super income stream as long as they do this within 90 days of receiving their personal injury settlement.^[9]

As these funds are contributed into super as after-tax contributions, the person will pay no tax on accessing these funds (assuming they can meet the permanent incapacity condition, which should be done before making the contribution). They will also pay no tax on the earnings within a super income stream account – and can effectively use this as a fully tax-free bank account. These tax savings can be worth thousands to hundreds of thousands of dollars in tax savings per year, depending on the size of the personal injury settlement.

IMPACT OF RECENT LEGISLATION ON TPD CLAIMS

Unfortunately, two pieces of legislation in the last four years have had a negative impact on the superannuation TPD area in Australia, and will continue to have a significant impact on TPD claimants. In the past many TPD claimants had multiple super accounts and TPD claims, these days most claimants will only have one TPD claim. This has reduced the number of TPD claims approved every year.

Treasury Laws Amendment (Protecting Your Superannuation Package) Act 2019 (Cth)

This legislation came into effect on 1 July 2019 and has caused the cancellation of insurance cover on inactive super accounts.

This legislation also now requires all superannuation accounts to report and rollover ‘low balance inactive accounts’ to the ATO every six months. This has not just caused the loss of insurance: for some TPD claimants it also means a significantly higher tax amount will be paid after their super TPD claim is approved because the rollover has brought across the earlier eligible service date to the new super fund, increasing the tax payable on withdrawal.

The Australian Lawyers Alliance (ALA) Superannuation & Insurance Special Interest Group lobbied the federal government and ATO for carve outs to protect TPD claimants from this unintended consequence of the legislation, but was unsuccessful.

Treasury Laws Amendment (Your Future, Your Super) Act 2021 (Cth)

This legislation is aimed at ensuring superannuation funds lift their standard, providing some much needed protection for passive Australian superannuation members.

Schedule 1 of the Treasury Laws Amendment (Your Future, Your Super) Act 2021 (Cth) defines the ‘stapled fund’ requirement. This means that when an employee commences with a new employer, the employer cannot automatically set up a new default super account for that employee without first checking with the ATO to see if the person has an existing active super account.

This legislation will in effect mean many Australians are ‘stapled’ to the first super account they have ever set up, and as we know different super accounts and the automatic insurance cover attached will be of different levels and of different quality.

LITTIGATED AND OTHER SETTLEMENTS

When TPD and other personal insurance claims are declined and litigated, the approved settlement will have different financial implications to those outlined above.

It is likely that litigated settlements relating to TPD will only be paid directly to the plaintiff, tax-free. Litigated and settled income protection claims are more complicated, they will generally be fully taxable at income marginal tax rates to the plaintiff but can have components that are non-taxable or taxed as capital gain, which can attract the capital gains tax 50 per cent discount. These people should get tax advice from a specialised accountant.

Lump sum back payments of income protection may be automatically taxed as though they are received in the current financial year, however, usually the lump sum payment in arrears tax offset may be applicable to significantly reduce the tax payable on these lump sums.

If a person is on an income protection claim and the insurer agrees to make a partial lump sum payment, to pay out any future payments on the IP policy, unfortunately these lump sums are generally fully taxable as income when received. For large settlements, this can mean almost half of the benefit is paid in tax. However, there may be tax reduction strategies applicable to reduce the tax impact.

CONCLUSION

When engaging new superannuation TPD insurance clients, it is a good idea to tell your client three things:

1. Do not consolidate your super accounts.

2. There could be tax, Centrelink and other financial implications if your claim is approved.

3. You will have options and can likely minimise or avoid paying tax or losing other benefits.

Before your client signs their superannuation withdrawal form to access their TPD (and superannuation) benefit, make sure they understand any implications triggered by signing this form.

Andy Reynolds is an independent financial adviser, the director and principal financial adviser at www.TPDClaimsAdvice.com.au. He partners with personal injury law firms around the country and is a member of the ALA’s Superannuation & Insurance Special Interest Group.

^[1] For further information on taxation of superannuation benefits before and after preservation age, age 60 and for untaxed superannuation schemes, see: ATO (2 August 2023) Tax on super benefits <https://www.ato.gov.au/individuals/super/withdrawing-and-using-your-super/tax-on-super-benefits/#Howsuperistaxed>.

^[2] Subdivision 307-145 of the Income Tax Assessment Act 1997 (Cth) explains the modification for disability super benefits formula.

^[3] These are estimated figures based on discussions with members of the Australian Lawyers Alliance (ALA) Superannuation & Insurance Special Interest Group. Following COVID-19 the ALA was involved in lobbying superannuation funds to leave TPD proceeds in a cash option rather than automatically investing the proceeds.

^[4] See Services Australia, Superannuation (3 March 2022) <https://www.servicesaustralia.gov.au/superannuation?context=22526> for information on treatment of superannuation accounts by Centrelink for pensions and allowances. Super is excluded from means testing while a person is under pension age.

^[5] See s4.8.2.30 of the Australian Government’s Social Security Guide (to social policy law) (14 August 2023), which explains that lump sum superannuation withdrawals are not counted as income for Centrelink benefits.

^[6] Ibid. Section 4.4.1.10 explains attribution of income on financial assets via deeming.

^[7] The ATO’s view was confirmed in the National Tax Liaison Group’s Superannuation Technical Subcommittee meeting held on 4 September 2007, as per agenda item 8.3 of the meeting minutes, which can be found on the ATO’s Legal Database: <https://www.ato.gov.au/law/view/document?docid=rtf/ntlg20070907>.

^[8] Social Security Guide, above note 5, s4.9.3.30 explains the means testing of superannuation income streams. Since 31 December 2014 super income streams have been counted as ‘financial assets’ and deeming applies.

^[9] As sub-div 292-95 of the Income Tax Assessment Act 1997 (Cth) explains, non-concessional superannuation contributions from personal injury settlement proceeds are excluded from contribution caps and must be done within 90 days of receipt of settlement.