Understanding the intricacies of income protection insurance within a self-managed superannuation fund (SMSF) is crucial to navigate the compliance requirements and taxation rules effectively. While income protection insurance is typically held outside of superannuation due to tax deduction advantages, some opt to include it in their SMSF for various reasons. However, doing so requires careful consideration of temporary incapacity benefit regulations. 

Income protection insurance proceeds received by an SMSF are not assessable income but fall under Capital Gains Tax provisions, ensuring tax-free treatment for the fund. When paying a temporary incapacity benefit to a member, the SMSF must adhere to strict compliance standards, including defining temporary incapacity, payment limits, and tax withholding obligations. 

The common mistakes I see in relation to an SMSF paying a temporary disability payment are: 

• Including the insurance proceeds as assessable income of the fund. 
• Simply passing the full amount of the monthly insurance proceeds to the member. 
• No PAYG withholding registration; withholding or reporting. 
• Disclosing only the taxable component of the payments from the superannuation fund in the individual’s tax return as a superannuation pension and claiming a 15% tax offset (Item 7 of the individual tax return). 

In addition to non-compliance with the SIS payments standards, this can result in the individual being assessed incorrectly for tax purposes. Where an SMSF member wants to have their fund hold income protection insurance, rather than in their own name, be sure to educate them on the rules, restrictions and administration requirements, not to mention the potential additional administration and audit costs.