Benjamin Franklin once said there are only two things certain in life: death and taxes. But what happens when these two certainties meet? If you’ve chosen your life insurance policy wisely, you can shield yourself from the financial impacts of both!
Are Life Insurance Pay-Outs Taxed?
Fortunately, in Australia life insurance benefits are usually tax-free, leaving terminally ill policyholders or grieving beneficiaries free to spend the lump sum payment they receive however they see fit.
There are, however, two major exceptions to this tax-free rule that both policyholders and beneficiaries need to be aware of:
- Payment of benefits for policies held within superannuation and;
- Payment of key person insurance benefits (life insurance for key business personnel)
Benefits from these types of policies are sometimes taxable at rates of 30%, and with life insurance policies often worth six figures or more, it’s vital to know if a policy’s beneficiary will never even see a third of that money! It is important to note that this figure of 30% is reflective of the company tax rates at the time of this blog post and they are subject to change.
Tax Considerations for Life Insurance Policies Held Within Super Funds
Many people choose to hold their life insurance policies within their superannuation funds because doing so allows them to claim the cost of their premiums as tax deductions – something you cannot do with a personal protection life insurance policy held outside of a super fund.
But, when it comes to claiming a life insurance benefit from a policy held within a superannuation fund, things become a little more complicated.
This is because life insurance policies form part of a superannuation fund’s “death benefit”, and whether a death benefit is taxable depends on if the beneficiary is considered a dependent, under Superannuation and taxation law, to the policyholder.
Generally speaking, people who are considered by the Australian Taxation Office to be dependent on a policyholder include:
- The policyholder’s spouse (this can include a de facto spouse of the same or opposite sex)
- A former spouse
- Children under the age of 18
- Another type of financial dependant or;
- Someone with whom the policyholder had an interdependent relationship with
It is important to note that there are differences between what is required to be considered a dependent under superannuation legislation (SIS Act) and under taxation law. These differences can result in significant complications should you require a payout. It is important to seek advice from financial adviser when weighing up your options.
Life insurance policies within superannuation funds can lie dormant for decades, and often the benefits of these policies are significantly reduced when policyholder’s children turn18 and are no longer considered financially dependant by the ATO.
Do Beneficiaries of Key Person Insurance Policies Have to Pay Tax on a Pay-Out?
Key person insurance is a type of life insurance that businesses take out to protect themselves from the loss of a person who is vital to the success of their business, be they a partner, a director or a staff member with skills that are crucial to the business’ functioning.
The benefits of key person life insurance policies are rarely tax-free.
Paying Income Tax on Key Person Insurance:
Businesses often take out key person insurance to protect their revenue (by covering losses, training replacements or paying debts, for example). When this insurance is purchased to mitigate revenue losses, any life insurance benefits paid will be seen as income and the benefits of the policy will be taxed accordingly.
Paying Capital Gains Tax (CGT) on Key Person Insurance:
If a business takes out a key person policy for a capital purpose (such as repaying a debt if a key person dies), then the benefit of that policy will not be subject to income tax, but the business may still have to pay capital gains tax.
This is because the ATO views the payment of the life insurance policy as the disposal of a CGT asset.
But, before you worry about whether payment of your key person insurance benefits might be considered a capital gain, take a moment to familiarise yourself with the two major exemptions the government has put in place.
Under section 118-300 of the Income Tax Assessment Act 1997, the law states that CGT is not payable on a life insurance benefit when:
- The life insurance benefits are distributed to the “original beneficial owner” of the policy (note that this could mean two or more people who have joint ownership of a policy or it could also be a business or a trust) or;
- The person receiving the benefits of the policy “gave no consideration” in exchange for the life insurance cover.
In this context, an “original beneficial owner” is the person who first possesses or controls the policy.
And, “consideration” is a legal term that, when talking about CGT exemptions for life insurance policies, basically means doing or giving something in exchange for something else. This could be paying money, giving gifts, offering rights or making another sort of exchange.
Find Out More About Life Insurance Taxation
If your head is spinning from the complexity of the taxation laws surrounding life insurance payouts, you’re not alone! Life insurance taxation is a complicated area of finance, and at Cover Australia, we take phone calls every day from people trying to determine which life insurance product will work best for their family or business.
For professional advice about life insurance, including queries about taxation, get in touch with one of our advisors today. We will answer any questions you have, no matter how complicated they may be!
General Advice Disclaimer
General advice warning: The advice provided is general advice only and in preparing it we did not take into account your investment objectives, financial situation or particular needs. Before making an investment decision on the basis of this advice, you should consider how appropriate the advice is to your particular investment needs, and objectives. You should also consider the relevant Product Disclosure Statement before making any decision relating to a financial product.