Taxation Of Income Protection Policies

A recent article in Personal Finance has once more brought to the fore the question of tax break changes on income protection policies. Here are some thoughts from FMI’s perspective:

The facts

• National Treasury has proposed that the tax treatment of income protection policies change effective 1 March 2014. From that date, it is proposed that premiums payable on income protection (IP) policies will no longer be deductible, and benefits received from IP policies will not be taxed.
• The proposed changes are included in the Tax Amendment Bill tabled following this year’s budget speech. The Tax Amendment Bill must still be approved by Parliament.
• According to the explanatory memorandum to the bill, the changes will apply equally to existing policies and policies purchased after the effective date, and no allowance will be made for the period of time a policy was in-force prior to the effective date i.e. premiums will no longer be deductible and benefits no longer taxable for all IP policies from the effective date. No transition period is envisaged.
• ASISA has put forward a discussion paper strongly resisting the proposed changes and arguing for a postponement of the implementation date to allow the market time to make the necessary adjustments.

What are the likely impacts?

Overall, the impact on individual policyholders should be negligible. New policyholders will buy lower cover (at a proportionally lower premium) which should largely offset the removal of premium deductibility. Because benefits will no longer be taxed, the reduced cover amount should leave the client in a neutral net position on claim.

Similarly, existing policyholders may choose to reduce policy cover and premium levels to a point where they are largely neutral to the change. They may also benefit from the change in a number of ways:

• They have already enjoyed premium deductibility benefits for a period, but will not be taxed on any future claims.
• Where clients choose to reduce cover and premium levels, they will enjoy the immediate benefit of reduced monthly premium cost, rather than the deferred annual benefit of premium deductibility.
• Where the existing client chooses not to reduce their cover amount, they will enjoy an increase in the effective income replacement ratio they are insured for.

An immediate impact for existing clients is that the change may result in them becoming over-insured. Over-insurance is a concern for product providers since it is regarded as an artificial claim incentive. In this case, providers would need to enforce premium and cover reductions. However, as the average income replacement on FMI new business is approximately 75%, most FMI clients would not be affected.
It is not clear how claims in payment at the date of change will be treated. Most likely these individuals will enjoy an immediate and substantial improvement in the net value of benefit payments.

Depending on the value that policyholders place on (deferred) premium deductibility benefits, the new basis could make the sale of IP policies easier due the substantially lower gross premium payable up-front.

The proposed changes will simplify individual tax administration at claim stage, as the client no longer needs to liaise with SARS or reserve for future tax liability (assuming PAYE is not deducted by the product provider).

Similarly, removing the distortion in tax treatment between Income and lump sum benefits should simplify the financial advice process and client purchasing decisions.

Of concern, however, is that the new tax treatment may change the perceived attractiveness of lump-sum disability benefits over income benefits. FMI argues strongly that lump sum disability benefits are not appropriate as a mechanism for insuring a recurring income, and the logic underpinning this argument does not change. Note also that any income earned by investing a lump sum disability benefit to produce a recurring income will likely incur some level of tax, whilst IP benefits will be entirely tax-free under the new regime.