Income protection for the self-employed

Why the self-employed need it most

Employees usually have a few weeks of paid sick leave and, for work injuries, their state's workers compensation scheme. Most self-employed people have neither. Workers compensation schemes are built around employees, so most sole traders aren't covered unless the rules in their state and the way they are engaged say otherwise. Check with your state regulator if you are unsure.

Moneysmart suggests income protection matters most for people who don't have much paid leave and rely on the income they earn to pay the bills. That describes most sole traders, and it applies twice over if the business has its own costs that keep running while you are off.

How insurers work out a self-employed income

APRA's income-at-risk measure, in force for new policies since 1 October 2021, says benefits should be based on income at the time of claim. Where income is stable, that means annual earnings in the 12 months before the claim. Where income varies, APRA expects the insurer to use average annual earnings over a period appropriate to your occupation. APRA also says income at risk should be based on income from personal exertion, so passive income such as rent, interest or dividends generally doesn't count.

For a sole trader, insurers generally look at what your own work earns after business expenses. For a company director it is usually salary and what the business earns from your work, depending on the policy's definition. The PDS defines income for your situation, and that definition is worth reading before you compare prices.

An illustration: how averaging a variable income changes the benefit

This shows the method only, with made-up figures and no premiums. A sole trader's net income from their own work was $90,000, then $60,000, then $54,000 in the year before a claim. A policy that used only the last 12 months would base the benefit on $54,000. One that averaged the three years would use $68,000. The difference flows straight into the monthly payment.

Your policy sets the averaging period and the percentage it replaces, within APRA's limits of 90% of income for the first six months of a claim and 70% after that. Ask how it treats a bad year before you buy.

Income protection vs personal accident and illness vs workers comp

Three kinds of cover get confused when you work for yourself. Only two of them can cover you, and they work quite differently:

Income protection for casual workers and contractors

Casual employees and contractors can apply for income protection, but two rules decide whether a policy fits. The first is hours: several direct policies only accept people who work a minimum number of hours a week. NobleOak's Premium Life Direct and the nib and Budget Direct policies, all issued by NobleOak, ask for at least 20 hours a week when you apply; Medibank's and ahm's, issued by Zurich, for between 20 and 60 hours. If your shifts often fall below that, check the PDS before you apply and answer the hours question accurately.

The second is income. Casual and contract earnings often vary, and for new policies APRA expects insurers to base the benefit on average earnings over a period suited to the occupation where income varies, rather than one good or bad stretch. Ask how the policy treats gaps between contracts or shifts, because the PDS definition of your income and of being at work decides what a claim pays.

Workers compensation fills only part of the gap. A casual employee is usually a worker, so the employer's policy covers work-related injury and illness, but nothing that happens outside work. A contractor on an ABN may or may not count as a worker under their state's test, which our state workers compensation guides set out. If an employer pays super for you, check whether your fund gives you default income protection: it doesn't start automatically for new members under 25 or while the balance is under $6,000, and it stops after 16 months without contributions unless you ask to keep it.

Evidence at application and at claim

Expect to show income when you apply and again when you claim. Moneysmart lists what insurers ask for at claim time: medical reports and test results, details of your work duties and hours, and payslips and tax returns, or financial statements if you are self-employed. Keep tax returns and financial statements for several years in order, and make sure what you declare to the insurer at application matches what your tax returns will show. A benefit is paid on proven income, not on the figure you picked when you applied.

Choosing a waiting period when you run a business

The waiting period is how long you must be unable to work before payments begin. Moneysmart says most policies offer between 14 days and two years. A longer wait lowers the premium, but only if you could survive it: savings, a partner's income, or work that others in the business can carry for you.

Many policies pay monthly in arrears, which means the first payment can arrive some weeks after the waiting period ends. Check when the first payment would be made and build that into the buffer you plan to rely on.

Business expenses insurance is separate

Income protection replaces your personal income. It doesn't pay the rent on your premises, staff wages or loan repayments of the business. Some insurers sell business expenses insurance for that: it reimburses your share of fixed business costs for a limited period while you can't work. APRA has said its income protection limits aren't aimed at products like this that cover business expenses or loan repayments, so the two are designed and priced differently. If your business carries fixed costs, ask about both and how they interact.

Tax and super for the self-employed

The ATO says premiums for insurance against the loss of your income are deductible, and payments that replace your income must be included in your tax return. If you are a sole trader, ask your registered tax agent where the deduction belongs on your return, because business income and personal deductions are reported in different places.

You can also hold income protection through a super fund you contribute to personally. The premiums then come out of your super rather than your pocket, and you can't deduct them yourself. If you claim a tax deduction for personal super contributions, the overall effect can be similar, but benefit periods in super are often shorter. Weigh the cover, not only the tax.