In a self-managed super fund (SMSF), insurance policies are held and managed by the fund itself. The SMSF owns the policy and pays the premiums, which are generally tax-deductible to the fund. If a claim arises, the insurer pays the benefit to the SMSF, which then allocates the proceeds to the member or their beneficiaries in line with superannuation law and the fund’s trust deed.
While insurance is not mandatory, the trustee must consider whether it’s appropriate for each member under Reg 4.09A. This article explains the compliance aspect of insurance and how it works in an SMSF — including life, total and permanent disability (TPD), temporary disability (income protection) and terminal illness cover — and outlines how premiums, proceeds, and benefit payments are generally treated for tax and compliance purposes.
Considering insurance in the fund
Every SMSF trustee must document that they have considered insurance for each member. This doesn’t mean the fund must actually hold cover, but the decision should be clearly noted in the investment strategy. This ensures the fund meets its compliance obligations.
During our audits, we noticed that many investment strategy templates include a sentence that the trustees will consider insurance cover for the members, which is not sufficient for the requirement of Regulation 4.09.
What cover an SMSF can hold
Under Regulation 4.07D, an SMSF can hold insurance for death, terminal illness, total and permanent disability (TPD) based on an ‘any occupation’ definition, and temporary incapacity (income protection). Trauma or ‘own occupation’ TPD policies are no longer allowed unless the cover existed before mid-2014. Because many retail policies bundle policies together, it’s common for SMSFs to hold combined covers.
Ownership and payment of premiums
The insurance policy must be owned by the SMSF trustee on behalf of the fund. The fund cannot purchase or take over an existing personal policy from a member. Instead, the policy should be newly issued in the fund’s name. Premiums must be paid from the member’s own balance within the fund, not from another member’s account.
Claiming premium deductions
SMSFs often claim a tax deduction for insurance premiums to lower the fund’s taxable income. Full deductions are available for income protection, life insurance (which typically includes terminal illness cover), and ‘any occupation’ TPD cover. Policies for ‘own occupation’ TPD, where grandfathered, however, offer only a partial deduction. A critical consideration is that deductions for life insurance premiums will influence the tax applied to death benefits, especially for beneficiaries who are non-dependants.
in certain circumstances, a fund may opt for a ‘future service deduction’ at the time a death, disability, or terminal illness benefit is paid. This election affects current and all future premium deductions for the fund and will be discussed in more detail later.
When insurance proceeds are received
When an insurance claim is paid, the proceeds are received by the SMSF and credited to the member’s account. These payments are not taxed at the fund level. The fund generally acts as a “pass-through” vehicle, with tax consequences arising only when a benefit is paid out to a member or their beneficiaries.
How payments can be made to members
Superannuation law requires that a member must meet a specific condition of release before their super benefits, including insurance proceeds, can be paid out. The fund’s trustee must be satisfied that this condition has been met before any payments are made.
The relevant conditions of release for insurance payouts are:
- Death
- Permanent Incapacity (TPD)
- Temporary Incapacity
- Terminal Medical Condition
Once a condition of release is met, the benefits can be paid as a lump sum or a pension (income stream), except that temporary incapacity benefits must be paid as a non-commutable income stream (not a lump sum). The payment is not limited to the insurance proceeds and can include the entire superannuation balance, except that amount of temporary incapacity payment is capped at the level of the member’s pre-incapacity income.
Compulsory cashing vs. voluntary payments
A key difference between these conditions of release is whether the payment is a compulsory cashing event.
- Death is the only event that legally requires a fund to pay out a member’s benefit. The benefit must be “cashed” as soon as practicable after death, either as a lump sum or a pension to an eligible beneficiary.
- For the other conditions of release—permanent incapacity, temporary incapacity, and terminal illness—the member is not required to withdraw their super benefits. Although rare in practice, in theory they can keep the insurance proceeds and other super funds within the SMSF to continue investing at concessional tax rates until they are ready to access them.
Death benefits: how tax works
The tax outcome depends on the relationship of the recipient to the deceased and the payment method.
- A lump sum to a dependant is entirely tax-free.
- For a death benefit pension to a depeneant, the tax outcome depends on the ages of the deceased and the beneficiary.
- A lump sum to a non-dependant is generally taxable, with different rates applying to the taxed and untaxed components.
Further reading
- How death benefits are taxed in an SMSF
- How untaxed element is calculated for the life insurance payout
Total and permanent disability (TPD) benefits
When a TPD claim is paid, the proceeds enter the SMSF and are not taxed in the fund. The payment to the member is treated as a disability super benefit. The condition of release requires a super fund’s trustee to be satisfied that the member’s ill health (physical or mental) makes it unlikely they will ever again engage in any gainful employment for which they are reasonably qualified by education, training, or experience. This is often called the “any occupation” test.
The member receives a higher tax-free component, based on the number of years between the date of disability and their retirement age.
How the “tax-free uplift” works
When a member receives a disability super benefit as a lump sum before age 60, their fund can apply a “tax-free uplift” to the payment. This calculation increases the tax-free component of the lump sum, reducing the overall tax. The uplift is based on the period from the date of permanent disability to their retirement age, generally age 65. Unlike lump sums, the tax-free uplift is not applied to pensions.
The formula is:
- Tax-free Uplift = Amount of Benefit x Days to Retirement/(Service Days + Days to Retirement)
- Amount of Benefit: The total disability benefit paid
- Days to retirement: The number of days from the date of disability until age 65
- Service days: The number of days the member was part of the super fund. However, the start date may be an earlier day where benefits are rolled over from another fund with an earlier service period start date – the earlier start will be applied to the new fund.
The younger the person is when they become disabled, the higher the tax-free component will generally be.
Unlike death benefits, no ‘untaxed element’ arises from deductions claimed for TPD cover.
Terminal illness benefits — tax-free lump sum
If a member has a terminal medical condition, they can withdraw their superannuation as a tax-free lump sum payment. To be eligible, two registered medical practitioners must certify that the member suffers from an illness or injury likely to result in their death within 24 months. At least one of the doctors must be a specialist in the area of the illness.
Important note: The lump sum remains tax-free only if it is withdrawn within the 24-month certification period. Any funds remaining in the super account after this period ends may be subject to tax.
The optional future service deduction
Instead of claiming annual premium deductions, an SMSF may choose to claim a one-off ‘future-service deduction’.
- Death
- Terminal Medical Condition
- Permanent Incapacity (TPD)
- Temporary Incapacity (paid as an income stream)
In practice, this can be a large deduction for the fund, but it comes with strict conditions: It applies only if the member’s employment was terminated due to the qualifying event. The member must have been working at the time. A premium must have been paid that same year. And the trustee must give up all current and future premium deductions of all sorts for all members.
Further reading: Future service deduction
Frequently Asked Questions
Are insurance proceeds taxed in the super fund?
No, they are not taxed in the super fund. They are taxed as member benefits or death benefits when the money is taken out of the fund.
I have received a temporary/permanent incapacity insurance payment. Do I have to take the money out?
No, temporary/permanent incapacity is not a compulsory cashing event. The insurance proceeds can stay in the super fund.
Does the tax-free uplift apply to pensions?
The tax-free uplift applies only to a lump sum. If it’s taken out as a pension, the tax components don’t change, although a 15% tax offset may be available on the income stream.
What audit evidence is required for TPD payment from super?
For SIS purposes, the condition of release is met if the trustee is reasonably satisfied that the member is unlikely to ever engage in gainful employment for which the member was qualified. The TPD insurance payout itself can be good audit evidence. However, for tax purposes, for the payment to qualify as a disability superannuation benefit, two legally qualified medical practitioners must certify the member’s condition.
Summary
Insurance in an SMSF is a complex area. Trustees should ensure ownership, premium payments, and documentation are correct, and understand how insurance interacts with benefit payments. Properly structured insurance can protect members and their families without creating unnecessary tax or compliance issues.