Are life insurance benefits subject to capital gains tax (CGT)? Find out what you need to know.
Life insurance policies are considered a capital gains tax asset and may be taxable at the time the policy becomes payable. The Australian Government recently made some changes to how capital gains tax is assessed. These changes affect everyone who owns or is named as a beneficiary in a life insurance policy.
CGT and term life insurance
Life insurance payments are typically taxed as a disposal of a capital gains tax asset. However, the government has put in place a few exemptions that would eliminate the persons need to pay taxes on payments from a term life insurance policy. The following two exemptions are in place for term life insurance policies:
- The life insurance proceeds are distributed to the original beneficial owner of the policy at the time the policy was put in place.
- If the person receiving the proceeds from the life insurance policy did not pay any fees or gave no consideration to the purchase of the life insurance cover.
What does original beneficial owner mean?
To understand this better, you must first understand what the term original beneficial owner means. The original beneficial owner is the first person who was put in place to control the payout of the policy when the owner of the policy has died. This may not be the actual owner of the policy. This can get a little tricky when there are multiple beneficiaries, such is the case with a life insurance policy that is held by the surviving partners in a business. If any of these partners have changed from the time the policy was purchased until the owner of the policy’s death, the partners would not be exempt from paying taxes. To avoid this dilemma, a business must take out a new policy and cancel the old one each time a new partner is brought into the company.
What does consideration mean for capital gains tax in life insurance policies?
You must also understand what consideration is to determine if you would be exempt or not. Consideration is typically an agreement to pay or do something in exchange for something else. For example, if you paid for a portion of the life insurance, you would not be exempt unless you were the original beneficial owner. Consideration can also include the exchange of a type of property, giving and/or receiving certain benefits in exchange for the life insurance payout, or an exchange of the life insurance policy. Basically, you could not have received or given any goods, services, benefits, assets or money in exchange for the payout from the life insurance policy in order to be exempt from taxes.
CGT, trauma and total and permanent disability (TPD) insurance
These exemptions do not hold true for payments made through a trauma or total and permanent disability (TPD) insurance policy. However, certain payments under this type of policy are still exempt.
CGT exemptions apply to trauma and TPD insurance if the cause of claim was due to a disability related to occupation or personal events
Trauma or TPD payments made to a person who was injured or suffered an illness or disease that was directly related to their occupation or personally under the guidelines set forth in section 118-37 ITAA97 are exempt from capital gains tax. It should be noted that this exemption is not only for physical injuries, but also covers various diseases and illnesses, as long as the cause of the injury or illness fits under section 118-37 ITAA97.
CGT exemptions apply when benefit is paid a family member
To be exempt from paying capital gains tax the insurance payments must go to the owner of the policy directly or his/her spouse or family member as defined under the law. A family member is considered to be a:
Will CGT exemptions apply if benefits are paid to a business partner?
Trauma and TPD policies owned by business would not be exempt if payments were being made to a non-related business partner. Payments that are directly made to the owner of the policy, who is injured or ill, would still be exempt. Companies that own a policy for a key employee will either pay taxes on these payments as a capital gains tax or just as ordinary income to the business. Typically, this depends on how the policy was structured and who specifically receives the payments from the insurance company.
CGT exemptions on other types of life insurance
There are various other types of life insurance policies and ways to set up and obtain a life cover policy for you and your family members. Each type of policy has its own set of capital gains tax regulations and it will depend on how you set up your policy to determine if the payments will be taxable or not. It is important that you understand these differences so you can be sure to obtain a life, trauma or TPD policy that provides that great tax savings possible. Here is a look at some of the most common alternative types of life insurance policies and how they are affected by the capital gains tax exemption.
Non-death insurance policies
Non-death insurance policies, such as trauma insurance and TPD insurance also have special exemptions from the capital gains tax. If the owner of the policy if injured or becomes ill personally or through their work the payments may be exempt. The exemption depends on who is receiving the payments made by the insurance company. If the owner of the policy, his/her spouse, or a close relative are receiving these payments, then they would be tax exempt. As previously mentioned, the government considers a close relative a brother, sister, child, father, mother, grandparent, aunt, uncle, niece or nephew or any of their spouses. These payments can be made directly or through a trust fund. Non-related business partners do not qualify for these exemption and would therefore be required to pay taxes on these payments.
Insurance policies owned by family discretionary trusts
There are also exemptions put in place for insurance policies that are owned by family discretionary trusts. With this type of trust fund all payments from the trauma or TPD covers will be paid directly to the trust fund. These payments can then be distributed to any of the beneficiaries listed with the family discretionary trust and still be exempt if qualified. You will qualify for the exemption if the insurance policy was used as a debt reduction scheme to cover debts owed by the trust or the family member, or if a type of buy and sell agreement is developed by the family members of the trust.
TPD and trauma policies owned by fixed or unit trusts
If one of the trustees of a fixed or unit trust was making a claim on their TPD or trauma insurance policies, the exemption would depend directly on who is named as the beneficiary on the policy. If the trust was used to purchase property or a business owned by the family and the beneficiary is the owner of the policy or a family member, the payments would be exempt. If, however, the trust was used to purchase property or a business with a non-related partner and the payments are made to this non-related partner, the insurance payments would not be exempt. If the trust actually owns the property or business, payments can only be made to the listed beneficiaries, and will only be exempt if this beneficiary is related to the injured party.
Key person policies owned by fixed or unit trusts
In the case where two non-related people own a property or business that was purchased through the use of a fixed of unity trust equally, a portion of the insurance payout will be exempt. Since both parties have equal interest in the trust the insurance payment will be disbursed equally with half going to both parties. The half going to the injured or ill party for which the claim was made will be exempt from capital gains tax, however, the other party will have to pay these taxes on their portion of the insurance payments.
Buy/sell agreement owned by fixed or unit trusts
Just as with the key person policies owned by a fixed or unity trust, the buy and sell agreements are also split 50/50 between the two owners. The exception would be if the insurance policy was only owned by the individual who is ill or injured and the payments are only being disbursed to that individual or one of their family members, or if the policy was owned by a personal trust of the injured or ill party. In general terms, any payment made to the injured party or their family members is exempt and any payments made to the other party are not exempt.
When is life insurance exempt for capital gains tax?
The exemptions to capital gains tax vary slightly depending on how the policy was purchased, who is listed as the beneficiary, and who actually receives the payments from the insurance company. As long as payments are being received by the injured or ill party or one of their family members the insurance payout is typically exempt. It is when non-related parties have joint policies or serve as a beneficiary that capital gains tax may need to be paid. People entering into business together may do better to purchase separate insurance covers and ensure their beneficiaries are listed as one of their family members, or create a trust fund that the payments can be sent to and then distributed to family members.
Consult with an experienced tax agent when determining CGT exemptions on your life insurance policy
Capital gains tax can be quite confusing and it may be a good idea to check with your tax accountant before obtaining any type of life insurance policy. The accountant can make sure that you set your policy up correctly to provide you and your family with the best tax benefit possible. The insurance company may also be able to help answer any of your questions and help you determine who might be the best way to set up your life, trauma and TPD cover and who to select as a beneficiary. A little pre-planning now can help to save you a lot of money in taxes later.