The premiums you pay for your income protection policy are generally tax-deductible, potentially reducing your taxable income. However, it's essential to understand the specific terms of your policy, including the tax deductibility of premiums and the tax treatment of any income protection payments you might receive.

If you have any questions about your existing policy's tax implications or would like some clarity around how purchasing income protection insurance might affect your taxes, we're happy to assist. As Chartered Accountants we are unable to give you advice regarding whether or not income protection insurance is right for you, however, we can refer you to several financial planners or insurers should you wish to pursue this matter further.

What is income protection insurance?

Income protection insurance, also called salary continuance cover, safeguards individuals financially in case they can't work due to illness or disability. If a policyholder faces this situation, the insurance typically pays a percentage of their pre-disability income, which can help the policyholder manage their expenses. Benefits usually activate after a waiting period. Terms can vary among providers, allowing policyholders to tailor options, such as waiting and benefit periods.

Income protection premiums may be tax-deductible, offering potential benefits tied to factors like marginal tax rates and taxable income.

Tax deductibility of premiums

The premiums paid for income protection insurance are generally tax-deductible, offering individuals an opportunity to reduce their taxable income. This deductibility is based on the recognition of premiums as a necessary expense incurred in the pursuit of earning assessable income. Only premiums that you pay to protect your income (salary and wages) are tax deductible.

Exceptions to tax deductibility of income protection insurance

There are specific situations where tax deductibility does not apply to income protection insurance premiums:

Exception 1: Superannuation fund

If your income protection policy is associated with your superannuation fund, and the premiums are deducted from your contributions—contributions made with pre-tax dollars—no tax deduction is allowed. This is because the funds used to cover these premiums have not incurred income tax.

Exception 2: Capital sum

In cases where the income protection policy pays out a capital sum as compensation for injury, especially in instances of severe disability or injury, the premiums for such policies are not eligible to claim tax deductions. These policies are considered to provide compensation for injury rather than serving as income protection, rendering their premiums non-deductible for tax purposes.

Taxation of payouts

If an individual holds an income protection insurance policy and receives a payout due to illness or injury preventing them from working, the received payout is generally categorised as taxable income. This classification stems from the fact that the payout functions as a substitute for salary or wages that would have been subject to taxation had the individual been able to work.

There are two distinct types of payouts that may be received from an income protection policy:

Regular payment

These are typically a percentage of the individual's regular income and are disbursed on a monthly basis until they return to work or until the specified benefit period in the policy concludes.

Lump sum payment

These are one-time payments that an individual might receive under specific circumstances, such as a provision for total and permanent disability within the policy.

If you receive a payment for personal injury or total and permanent disability, the payment is considered capital and may be assessed as a capital gain.

It's important to bear in mind that tax laws can be intricate, and individual circumstances may differ. Seeking tax advice from a professional is always advisable to navigate the complexities of taxation associated with income protection policies.

Payment reporting from income protection insurance

It's crucial that individuals declare in their tax returns any payments they receive from income protection, sickness, or accident insurance policies. This declaration includes any compensations for lost salary or wages under these policies, even if connected to a workers' compensation scheme. The method of declaring these payments in the tax return depends on whether tax has been withheld:

How to declare income from insurance policies if tax is withheld

If tax has been withheld from your income protection insurance payments, individuals need to ensure the inclusion of these amounts in their tax returns. These withheld amounts will be detailed on their income statements or PAYG payment summaries.

How to declare income from insurance policies if tax is not withheld

In cases where tax has not been withheld from your income protection insurance payments, individuals are required to declare them as additional income in their tax returns. This is applicable if the premiums are deductible, the payments serve as a substitute for employment income, and they are not specified on the income statement or PAYG payment summary.

Policy holder's responsibility

The responsibility for checking whether tax has been withheld from the payments received under the income protection policy lies with the policy holder. Tax laws can be complicated, and individual circumstances may vary. Seeking advice from a tax professional or consulting the Australian Taxation Office (ATO) is always advisable.