Most of us are aware that superannuation benefits can be paid out on retirement (ie, after attaining your preservation age), as well as on suffering permanent incapacity and on death. However, many are not aware that our super savings can also provide some welcome relief on suffering temporary incapacity.
Those that suffer temporary incapacity can receive income support during their period of temporary incapacity. There are, however, strict rules that govern this support that need to be carefully understood. Moreover, not all super funds or SMSF deeds provide this support. Thus, it is worthwhile checking whether you are covered, just in case it is ever needed; if you are, it can be a welcome relief!
What is temporary incapacity?
Temporary incapacity is defined in regulation 6.01(2) of the SISR to mean:
‘temporary incapacity’, in relation to a member who has ceased to be gainfully employed (including a member who has ceased temporarily to receive any gain or reward under a continuing arrangement for the member to be gainfully employed), means ill-health (whether physical or mental) that caused the member to cease to be gainfully employed but does not constitute permanent incapacity.
We now contrast this definition with that of permanent incapacity, as we examine below a number of interesting points that arise from this comparison.
Firstly, we note that the definition of ‘temporary incapacity’ is ceasing gainful employment due to illness that falls short of permanent incapacity.
Secondly, there is no express criteria such as medical certification being required (as there is in the tax definition of ‘disability superannuation benefit’ as defined in s 995-1(1) of the Income Tax Assessment Act 1997 (Cth) (‘ITAA 1997’)).
Thirdly, the ATO has confirmed its view in TR 2012/6 at paragraphs , and  to  as:
- A ‘disability superannuation benefit’ is defined in s 995-1(1) of the … ITAA 1997 … to mean a superannuation benefit where:
- the benefit is paid to a person because he or she suffers from ill-health (whether physical or mental); and
- 2 legally qualified medical practitioners have certified that, because of the ill-health, it is unlikely that the person can ever be *gainfully employed in a capacity for which he or she is reasonably qualified because of education, experience or training.
- The general rules on payment of a member’s benefits from a superannuation fund are set out in Division 6.2 of the SISR [‘Superannuation Industry (Supervision) Regulations 1994 (Cth)’]. Under Division 6.3 of the SISR, the payment of a member’s benefits may be compulsory or voluntary.
- Consistent with the sole purpose test, a complying superannuation fund can only provide a member’s preserved benefits on or after the time when a member satisfies a condition of release (regulation 6.18 of the SISR). Schedule 1 to the SISR identifies the conditions of release for these purposes together with any restrictions that apply to the provision of benefits when certain release conditions have been met.
- The provision of a ‘disability superannuation benefit’ to a member is determined by reference to the entitlements of the member under the trust deed, and more particularly, the operation of the conditions of release in Schedule 1 to the SISR. Accordingly, the matter of when and to what extent a member receives a benefit referable to the payout under an insurance policy is not determined solely by the occurrence of the insured event and the receipt of a payout by the trustee of a fund under the insurance policy.
- The permanent incapacity of a member is listed in item 103 of Schedule 1 to the SISR as one of the conditions of release under which a superannuation fund can provide a benefit to a member and is the relevant condition of release that would have to be satisfied, in conjunction with the requisite two medical certificates, in order for a superannuation fund to provide a ‘disability superannuation benefit’.
- Subregulation 6.01(2) of the SISR defines permanent incapacity in relation to a member as:
ill-health (whether physical or mental), where the trustee is reasonably satisfied that the member is unlikely, because of the ill-health, to engage in gainful employment for which the member is reasonably qualified by education, training or experience.
- In our view the degree of ill-health that the trustee of a fund must be reasonably satisfied exists in order that a member meets the definition of permanent incapacity under subregulation 6.01(2) of the SISR is for all practical purposes identical to that which two medical practitioners must certify for the payment of a ‘disability superannuation benefit’. While the trust deed may not require certification by two medical practitioners for the purpose of satisfying the permanent incapacity condition of release, it would be expected that the trustee would rely on the advice of at least two medical practitioners in order to be reasonably satisfied that this condition of release has been met. For the purpose of obtaining a deduction within subsection 295-465(1) this would equate to the certification required for a ‘disability superannuation benefit’.
Broadly, the ATO has blended the ITAA 1997 definition of ‘disability superannuation benefit’ with the ‘permanent incapacity’ definition of SISR by stating that two medical certificates are required; despite the SISR definition not expressly covering this criteria.
What benefit can be paid on suffering temporary incapacity?
A member that suffers ‘temporary incapacity’ can obtain a non-commutable income stream (‘NCIS’). This NCIS:
- must be paid for the purposes of continuing (in whole or part) the gain or reward which the member was receiving before his or her temporary incapacity; and
- the payment must not exceed the period of temporary incapacity.
Clearly, a member cannot be paid a lump sum or by way of an account-based pension or transition to retirement income stream (‘TRIS’) if they suffer temporary incapacity (refer to condition of release — Item 109 of Schedule 1 to the SISR.
Also, the NCIS must not exceed the member’s pre-incapacity income (eg, salary or income from any business or profession earned by them prior to becoming temporarily incapacitated). One point to be aware of that income protection/continuation insurance is generally capped at 75% of the insured person’s gross income. Moreover, such insurance is usually reduced by any other income or compensation the insured receives. Thus, you should carefully examine the details of any income protection/continuation insurance held outside of super to see if there is a potential for the insurance support to be reduced on account of say an NCIS being provided by the member’s SMSF of $1,000 per week, which reduces the $750 insured benefit that would otherwise be payable if the NCIS was not provided.
Another example worth keeping an eye on is where employees that are on paid sick or personal leave are not eligible to receive an NCIS during the same period they are on that paid leave, unless the NCIS supplements their leave to the level of their pre-incapacity income.
Thus, where the member is self-employed or does not have any other entitlement or insurance to cover their temporary incapacity, an NCIS can provide welcome relief. In particular, if a member does have income protection/continuation insurance that provides up to 75% income replacement, then the NCIS payments could provide the remaining 25% of income that cannot be provided by, say, the SMSF.
Also, when the member returns to gainful employment, the NCIS must generally cease.
As discussed above, there are a number of strict criteria to consider when implementing this strategy. One further point that many do not fully understand is from what type of amounts in a superannuation fund that an NCIS can be funded from. These amounts can only be funded from so much of a member’s minimum benefits in a superannuation fund that do not relate to:
- member-financed benefits (broadly, member contributions made to the fund and investment earnings thereon); and
- mandated employer-financed benefits (broadly, compulsory employer contributions under the Superannuation Guarantee (Administration) Act 1992 (Cth) and investment earnings thereon).
Refer to reg 5.08(3) of SISR. It is important to note here that reg 5.08(3) is a modification to the usual minimum benefits test. Under reg 5.04(2) a member’s minimum benefits in an accumulation fund are all of the member’s benefits in the fund. Thus, reg 5.08(3) makes an exception to allow an NCIS to be funded for a member when they suffer temporary incapacity.
This means an NCIS can typically only be paid from a superannuation fund in respect of a member, from any one or more of the following:
- employer contributions in excess of the superannuation guarantee (‘SG’) level such as salary sacrifice contributions (currently FY2015 at 9.5% of ordinary time earnings). As discussed above, member and SG contributions plus earnings thereon are minimum benefits that cannot be used towards funding an NCIS under reg 5.08(3) of SISR;
- insurance proceeds received by the fund in respect of the member such as income protection/continuation insurance proceeds; and/or
- reserves maintained by the fund such as investment or general reserves. Note that contribution reserves can only be applied towards members and must usually be allocated within 28 days of the end of the month in which the fund received the contribution
Thus, to be able to implement this strategy, prior planning (enough to put in place an insurance policy inside the fund or, if reserves are to be used, it is best to start planning many years in advance, eg, between 10-15 years) is required to establish the funding mechanism that can provide an appropriate (NCIS) cash flow. If, on the other hand, the member’s benefits only comprise SG and member contributions plus earnings thereon (and the fund has no reserves or insurance proceeds), an NCIS cannot be provided.
Given most adults do not have much insurance cover, this could result in members being left to their own devices when they suffer temporary incapacity and have no resort to their super savings nor insurance. This can be very stressful and financially difficult for many self-employed people, particularly small business proprietors, farmers, artists, actors and trades people and contractors.
Ben is a farmer who has recently injured his back lifting heavy equipment, and is not expected to be able to undertake much work for a period of six months.
Ben has as income protection/continuation insurance policy in his own name that covers 75% of his gross earnings, however, to keep his premium lower he chose a 90 day waiting period before he is covered for loss of income.
Ben has an accumulation balance in the fund of $500,000. Ben’s benefits are all preserved benefits but his SMSF has accumulated $100,000 via investment reserving over the past 20 years to ensure there was a sufficient buffer in the fund for investment fluctuations.
Ben satisfies the ‘temporary incapacity’ condition of release but he can only receive moneys from the reserves in the fund to provide him an NCIS. He cannot receive any funds from his SG or member contributions plus earnings thereon due to reg 5.08(3) of SISR.
Further, for the first 90 days of his injury he can receive an NCIS up to the level of his pre-incapacity income. After that 90 day period, the NCIS can only provide the remaining 25% supplement to his income since his insurance policy will only pay 75% of his income after the first 90 days. The NCIS must cease when Ben resumes his usual gainful work and income level which is expected at the end of 6 months.
Another option for Ben would have been for his SMSF to effect insurance, in which case his NCIS could be partly funded by that insurance received (internally) by the fund. This is one advantage of having income protection/continuation insurance inside a superannuation fund.
What medical evidence is required?
The SISR does not require medical or other evidence. However, it is wise to collate appropriate evidence to be in a position to readily verify the illness and eligibility for an NCIS.
Is an NCIS for temporary incapacity taxable?
Ben’s NCIS will be taxable to John as ordinary assessable income (under s 6-5 of the ITAA 1997) and taxed at his marginal tax rates plus applicable levies, as it is not a pension or income stream like an account-based pension or a TRIS that is eligible for a tax offset if your under 60 years of age (refer: s 307-10(a) of the ITAA 1997).
Was temporary incapacity benefits impacted by the 2014 insurance changes?
There were important changes that apply from 1 July 2014 that impact on the type of insurance that regulated superannuation funds can provide after that date. From 1 July 2014, broadly, ‘any occupation’ permanent incapacity/disability superannuation benefit (aka, ‘total and permanent disablement (‘TPD’)) cover must only be provided. Other allowable cover post-June 2014 is for:
- terminal medical condition; or
- temporary incapacity.
It is interesting to note that there was no major impact from the mid 2014 insurance changes on temporary incapacity benefits. This is because the definition of ‘temporary incapacity’ is not contingent on by the ‘own occupation’ versus ‘any occupation’ distinction that relates to permanent incapacity/disability superannuation benefits. As discussed above, in broad terms a member is temporarily incapacitated if he or she is ill (mentally or physically) but is not permanently incapacitated (see definition from reg 6.01(2) of SISR above).
Fortunately, insurance effected in superannuation funds before 1 July 2014 is grandfathered and can continue indefinitely, eg, an ‘own occupation’ definition permanent incapacity policy. This broadly means that such ‘grandfathered’ insurance can continue in a fund in future years even if the policy cover is increased or decreased. Naturally, expert advice should be obtained to confirm your particular circumstances.
Also, at least an annual review should occur on whether the SMSF Trustees should hold a contract of insurance that provides insurance cover for one or more members of the fund in accordance with reg 4.09(1) of the SISR.
Naturally, SMSF deeds are very important in implementing this strategy. Many SMSF deeds do not even provide for temporary incapacity benefits nor do they cater for the special modification to the minimum benefits rule. Thus, a strategic SMSF deed is required and one that has a range of provisions that allow for covering insurance, reserving and other related aspects of appropriately managing this strategy.
In addition, reserving can provide an important funding mechanism for many who may not have insurance or may not be eligible to obtain insurance cover for health or other reasons.
DBA Lawyers offer strategic SMSF documents and advice including an investment reserving kit to assist in this strategy (http://www.dbalawyers.com.au/strategy-compliance-kits/).
All members should have a temporary incapacity strategy available just in case it is ever needed.
* * *
This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.
Note: DBA Lawyers hold SMSF CPD training at venues all around Australia and online. For more details or to register, visit www.dbanetwork.com.au or call Marie on 03 9092 9400.