Income Protection Insurance Australia | Protect Your Income

How Income Protection Insurance Works

Income protection insurance is designed to replace a portion of your income if you become unable to work due to illness or injury. Unlike life insurance, which pays out on death, or TPD insurance, which requires total and permanent disability, income protection provides ongoing monthly payments during temporary or long-term periods of incapacity. This makes it one of the most practically useful forms of insurance for working Australians.

When you take out an income protection policy, you choose three key parameters: your insured income (typically up to 75% of your gross earnings), your waiting period (the time you must be off work before benefits begin), and your benefit period (how long the insurer will continue paying benefits). These choices directly affect your premium — shorter waiting periods and longer benefit periods cost more.

If you become unable to work due to a covered illness or injury, you lodge a claim with your insurer. After satisfying the waiting period, the insurer begins paying your monthly benefit. This continues until you are well enough to return to work, your benefit period expires, or you reach the policy's end age (usually 65). If you return to work part-time while still partially disabled, most policies pay a proportional benefit to supplement your reduced income.

What Counts as a Covered Illness or Injury?

Income protection covers a wide range of medical conditions that prevent you from performing the duties of your occupation. Common claims include musculoskeletal injuries such as back, neck, and joint problems, mental health conditions including depression, anxiety, and stress-related disorders, cancer and related treatments, cardiovascular conditions including heart disease and stroke, surgical procedures and recovery periods, and chronic conditions that worsen over time.

Mental health claims have become one of the most common categories, particularly since the Covid-19 pandemic. Most modern income protection policies cover mental health conditions, though some may have specific waiting periods or benefit limits for mental health claims. Check the policy wording carefully if this is a concern for you.

Waiting Periods Explained

The waiting period, also known as the elimination period or qualifying period, is the number of days you must be continuously unable to work before the insurer starts paying your benefit. This is one of the most important choices you make when setting up your policy, as it directly impacts both your premium and how quickly you receive financial support.

Common Waiting Period Options

Most insurers offer waiting periods of 14 days, 30 days, 60 days, or 90 days. Some policies also offer 7-day or 180-day options. The shorter the waiting period, the sooner you start receiving benefits, but the higher your premium. Here is a general guide to how waiting period choices compare:

• 14-day waiting period: Benefits start quickly, but premiums are the highest. Suitable for self-employed people with no sick leave and limited savings.
• 30-day waiting period: The most popular choice. Balances affordable premiums with reasonably quick access to benefits. Suitable for most employees with limited sick leave.
• 60-day waiting period: Moderate premium savings compared to 30 days. Suitable for employees with 6-8 weeks of sick leave or sufficient savings to cover two months of expenses.
• 90-day waiting period: Significant premium savings — typically 20-40% less than a 30-day waiting period. Suitable for employees with generous sick leave, contractors with a financial buffer, or those prioritising lower premiums.

To choose the right waiting period, calculate how long you could sustain your living expenses using your sick leave entitlements, emergency savings, and your partner's income (if applicable). If you could manage for 90 days, choosing a longer waiting period can save you hundreds or even thousands of dollars per year in premiums over the life of the policy.

Benefit Periods Explained

The benefit period determines how long the insurer will continue paying your monthly benefit for any single claim. This is the maximum duration of support you receive if you are unable to return to work for an extended period. Choosing the right benefit period is crucial for ensuring adequate long-term protection.

Common Benefit Period Options

Benefit periods typically range from 2 years to age 65, with the most common options being:

• 2-year benefit period: The most affordable option. Covers short to medium-term incapacity but leaves you exposed if you cannot return to work within two years. Suitable as a baseline level of cover or for those on a tight budget.
• 5-year benefit period: A middle-ground option that provides meaningful long-term protection at a moderate premium. Suitable for most people, and the maximum available inside super under current rules.
• To age 65: The most comprehensive option. Ensures you are covered right through to retirement age regardless of how long your disability lasts. This is the gold standard but comes with the highest premiums. Only available outside super.

Consider what would happen if you were permanently unable to return to your occupation. A 2-year benefit period means you would need other resources — savings, partner's income, government support — after benefits end. A benefit period to age 65 provides ongoing income replacement until you reach retirement age and can access your superannuation. For most working Australians under 50, a benefit period of 5 years or to age 65 is recommended.

Tax Deductibility of Income Protection

One of the most attractive features of income protection insurance is its tax treatment. When held outside superannuation, income protection premiums are generally fully tax-deductible against your personal income. This is because the benefit payments, if you make a claim, are treated as assessable income and taxed at your marginal tax rate.

How the Tax Deduction Works

If you pay $2,500 per year in income protection premiums and your marginal tax rate is 32.5% (plus 2% Medicare levy), the tax deduction saves you $862.50. This reduces the effective cost of your policy from $2,500 to $1,637.50 per year. For higher-income earners in the 37% or 45% tax brackets, the savings are even more significant.

To claim the deduction, simply include your income protection premiums in your tax return under "Other deductions — income protection insurance." Keep your premium payment receipts and policy documents as records. Note that only the income protection component is deductible — if your policy includes life insurance or TPD cover, those premium components are not tax-deductible when held outside super.

Tax Treatment of Benefit Payments

If you make a claim and receive income protection benefits, those payments are treated as assessable income and taxed at your marginal tax rate. The insurer will typically withhold PAYG tax from your monthly benefit, similar to how an employer withholds tax from your salary. Because your total income is likely to be lower during a claim period (you are only receiving 75% of your pre-disability income), you may end up in a lower tax bracket, resulting in a lower effective tax rate on your benefits.

Income Protection Inside Super vs Standalone

The choice between holding income protection inside your superannuation fund or as a standalone policy outside super is one of the key decisions when arranging this cover. Recent regulatory changes have made this choice more nuanced than it was in the past.

Inside Super

Holding income protection inside super means premiums are paid from your super balance, preserving your take-home pay. Contributions are taxed at 15%, potentially making the effective cost lower than outside super. However, since 1 April 2020, income protection policies inside super are subject to new restrictions: benefit periods are limited to a maximum of 5 years, benefits must be reduced over time if you return to partial employment, and the income replacement ratio may be lower in the later years of a claim. These changes were designed to reduce erosion of super balances and maintain incentives to return to work.

Outside Super (Standalone)

Standalone income protection policies held outside super offer greater flexibility and typically more generous terms. Benefit periods up to age 65 are available, providing long-term protection. Premiums are personally tax-deductible, which can offset the higher out-of-pocket cost. You have more choice of insurers and policy features, including agreed value options, built-in benefits, and day-one accident cover. Claims processing may also be faster since there is no super fund trustee involvement.

The trade-off is that premiums come from your after-tax income rather than your super balance. However, the tax deductibility of premiums means the net cost difference between inside and outside super is often smaller than it appears. For someone in the 37% tax bracket, a $3,000 annual premium outside super effectively costs $1,890 after the tax deduction — compared to $2,550 inside super after the 15% concessional contribution tax.

Key Considerations

When deciding between inside and outside super, consider these factors: your cash flow and ability to pay premiums from after-tax income, the importance of a benefit period beyond 5 years, the value of the personal tax deduction at your marginal rate, your super balance and how much erosion from premiums you can tolerate, and whether you need agreed value or are comfortable with indemnity value. Many advisers recommend holding income protection outside super for the tax deduction and access to benefit periods up to age 65, but the right choice depends on your individual circumstances.