Once a member has satisfied the permanent incapacity condition of release, they will generally have the option to receive some (or all) of their proceeds as either a lump sum, a pension, or a combination of both.

Further, where TPD cover is held inside super, but the superannuation fund doesn’t have the ability to pay a benefit in the form of a pension, a client can elect to roll their benefit over to another superannuation fund from which a pension can be commenced.

When considering which option, or combination of options, is best suited to a particular client’s circumstances, a holistic view of their situation is required. Naturally, lump sum benefits are likely to be necessary to pay off debts or meet other immediate expenses, however commencing a pension may be a good way to meet ongoing income needs.

Where TPD proceeds are received in the form of a lump sum, tax may be payable. The rate of tax payable is determined by applying the table below:

Table 1: Tax on lump sum superannuation benefits 2023-24

	Age	Tax rate*
Tax-free component	Any	0%
Taxable component	60 or older	0%
	Preservation age <60	First $23,000 - 0% Balance - 15%
	Below preservation age	20%

* Excludes Medicare levy

The first observation that can be drawn from the above table is that tax is only applicable to the taxable component of a lump sum benefit.

Secondly, the client’s age at the time of the payment is instrumental in determining the rate of tax payable. For example, someone aged 60 or older will not pay any tax at all, while the highest rate of tax (i.e. up to 22%, inclusive of the Medicare levy) applies to clients who are yet to reach their preservation age.

Critical to the discussion of tax payable on superannuation TPD benefits is an awareness of how the tax components of a benefit are calculated – and to that end, an appreciation of the benefits unlocked when a payment is considered a disability superannuation benefit.

For a payment to be treated as a disability superannuation benefit, tax law broadly states that:

• The benefit is paid to an individual because he or she suffers from ill-health (whether physical or mental), and
• Two legally qualified medical practitioners have certified that, because of the ill-health, it is unlikely that the individual can ever be gainfully employed in a capacity for which he or she is reasonably qualified because of education, experience or training.

Where a disability superannuation benefit is paid as a lump sum, a client will benefit from an uplift (or increase) to the tax-free portion of their benefit. The amount of additional tax-free component is calculated in accordance with the following formula:

Amount of benefit    X Days to retirement
Service days + Days to retirement

Observations:

The tax-free uplift:

• represents an additional amount of tax-free component. Where a client’s benefit already contains some tax-free component, this additional amount will be added to their existing tax-free amount.
• applies to a lump sum withdrawal and to a lump sum rollover. It does not apply where a client simply commences a pension from the same fund.
• is available regardless of whether the withdrawal involves proceeds from a life insurance policy or not.
• decreases as a client gets older (i.e. fewer days to retirement), and/or the longer their eligible service period is (i.e. greater number of service days).

Example:

Ingrid, age 50, has $750,000 of TPD cover held through a risk only super policy established in July 2017. In July 2022 she became permanently disabled and accessed her $750,000 as a lump sum.

To work out the tax components of Ingrid’s benefit, we begin by applying the uplift formula discussed earlier:

Tax-free uplift = $750,000 X 5,479 (Days to retirement)
1,826 (Service days) + 5,479 (Days to retirement)

Tax-free uplift = $562,500 (rounded for illustrative purposes)

As she has no existing tax-free component available this $562,500 becomes her tax-free component. As a result, her taxable component is $187,500 ($750,000 – $562,500).

As identified earlier, only the taxable component will be subject to tax. And, as she is under her preservation age, the maximum 22% rate applies (including Medicare levy) – resulting in a maximum tax liability of $41,250.

Notwithstanding the potentially daunting maximum 22% tax rate, based on her age, initially identified in Table 1 (above), this amount of tax is equivalent to a 5.5% effective tax rate on her total benefit – highlighting the critical importance of identifying how the tax-free uplift operates.

Common Trap: Given the importance of a client’s eligible service period (ESP) when calculating the amount of tax-free uplift available, it’s important to be aware that paying premiums via rollover from another super fund will result in any earlier start date for the ESP that is attached to the originating fund, being transferred into the receiving fund, potentially extending the service days and tax that may be payable

While receiving at least some of the TPD proceeds as a lump sum will typically be necessary to meet a client’s immediate needs, it is not the only option available.

For example, clients could consider:

• Retaining surplus proceeds in the accumulation phase – a particularly attractive option for clients who may be reliant on Centrelink benefits (e.g. Disability Support Pension) following the onset of their disability as assets held in the superannuation accumulation phase, while under Age Pension age, are sheltered from Centrelink means testing.
• Using surplus proceeds to commence a pension – a tax-effective option for meeting a client’s ongoing income needs.

These options don’t immediately involve a lump sum withdrawal, so they will not attract any immediate lump sum tax. As a result, the more a client intends to divert into these options, the further any potential lump sum tax liability is lowered.

The application and benefits, as well as some of the associated strategic implications, of these alternatives will be covered in more detail in a future Talking Technical article.