Income protection policyholders may lose the tax deduction they enjoy for contributions paid on these policies as early as next year if a proposed amendment to the Income Tax Act is legislated as outlined in the Taxation Laws Amendment Bill.
However, in terms of proposed provisions in the bill, which was released for comment this week, should you become disabled, the monthly income you could receive from one of these policies will be tax free from the tax year beginning March next year.
The proposed implementation date is likely to be questioned when the bill comes before Parliament.
Nicholas van der Nest, the divisional director of risk products at Liberty Life, says implementing the proposal at such short notice will be a “significant challenge” for life assurance companies.
The explanatory memorandum to the bill clears up confusion about how existing income protection policies, on which you may have enjoyed tax deductions for many years, will be treated.
The memorandum says there will be no transitional period and the new system will “operate cleanly going forward”.
This means that no contributions paid from the date when the new system becomes effective will be tax deductible, and all payouts made from income protection policies to policyholders who successfully claim after being disabled will be tax free.
There were concerns that payouts from existing income protection policies would be partly taxed and partly tax-free in line with the period for which you did and did not enjoy a tax deduction on your premiums, but the bill makes it clear that this will not be the case.
Van der Nest says life assurers who are members of the Association for Savings & Investment SA (Asisa) are analysing the impact of the change for policyholders in terms of amending the premiums they pay and the impact on government in terms of the tax revenue it collects.
If the change is implemented, as an income protection policyholder, you will need to check on the monthly amount you can claim for disability, because the amount for which you are currently insured is based on providing a monthly pre-tax income, rather than the after-tax income you will require after the change is implemented.
This means that if the amendment is implemented, you may be able to insure yourself for a lower amount, because you won’t need to provide for the tax on your income.
You need to be sure that you are not overinsured – life assurers will generally only pay you out an income of 75 percent of what you were earning before you were disabled. They do this to ensure there is no incentive for clients to make opportunistic claims on these policies. (Some polices make exceptions if you are temporarily disabled or if your disability is one from which you will never recover.)
Van der Nest says life assurers will have to contact all their existing policyholders to inform them of the change and find out whether they need to adjust the income for which they are insured. This would be necessary to address the issue of overinsurance and to ensure policyholders are treated fairly in line with the Treating Customers Fairly principles that are to be legislated shortly, he says.
The explanatory memorandum to the Taxation Laws Amendment Bill says the aim of the amendment is to introduce consistency in the tax treatment of all non-retirement fund disability and income protection policies by denying tax deductions for contributions but allowing payouts to be tax-free.
Currently, some income protection policyholders enjoy tax deductions while others do not. According to Asisa, the South African Revenue Service is also treating the monthly income paid from income protection policies differently. In some cases policyholders who did not enjoy a tax deduction on their premiums are also being taxed on the payouts from these policies.
The tax deductibility of contributions may be a key attraction of income replacement policies, and there may be a shift to lump-sum disability policies should the proposed amendment be implemented.
You should remember that even if you lose the tax deduction for premiums on your income protection policy, this type of policy may enable you to match your cover to your income needs after disability much more closely than you can with a lump-sum disability policy. It may also offer protection against temporary disability, while lump-sum disability policies pay out only on permanent disability.