Written by Michal Lancemore
I’ve recently been learning more about Investment Bonds. Most of you may have already heard about investment bonds, and most of you may have discounted them previously based on preconceived ideas of what they provided in the past.
I’m here to let you know there is a new breed of investment bonds which are very enticing for many investors.
Investment bonds are long-term investments that may offer tax efficiency to investors on a high marginal tax rate. They may also suit:
- investors with a long-term investment horizon (at least 10 years)
- investors who have contributed as much concessional contributions to super as possible or maxed their super transfer cap
- parents or grandparents who wish to invest on behalf of the next generation
- investors who do not require access to their funds, as investment bonds re-invest distributions.
- Investors who are self-employed or in a highly litigious industry.
Below are some key reasons as to why an investment bond should be considered if you fall into any of the categories above:
Unlike managed funds, bonds are a ‘tax paid’ investment. This means that tax on investment earnings is paid at the applicable company rate of 30% by the bond issuer – not by you, the investor. However, when franking is taken into account the tax rate can be closer 12-15% (and sometimes 0%)!
The following table shows the tax benefits of an investment bond, for a tax payer on the highest marginal rate (assuming no franking):
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A big rule of investment bonds is that you do not contribute more than 125% of the previous year’s contributions – if you do, it resets the 10 year term.
By maximising the 125% rule, a bond investment becomes even more tax effective because it gives you the opportunity to make additional investments each year. The level of additional contributions you can make continues to increase until the end of the tenth anniversary, after which all withdrawals from the bond are tax-free. For example, if you invest $10,000 in year one, then, using the 125% rule, $12,500 (125% @ $10,000) may be invested in year 2, and so on.
10 year rule
Ideally, leaving a bond in place for 10 years maximises the tax benefit (withdrawal after 10 years is tax free!). However, even if you access after 8 years, there are tax concessions on the withdrawal from an investment bond:
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If your intention is to invest for 10+ years, and your marginal tax rate is above 30%, then an investment bond can provide some pretty good tax benefits.
Range of Investment options
Like managed funds, investment bonds on offer today provide a wide range of investment choice including cash, fixed income, property, shares, responsible investing, alternatives and diversified options. The underlying management fees are just like managed funds – the more active the investment option, the higher the cost.
Subject to certain rules, creditors can’t access your investment bond in the event of bankruptcy. If you work in a highly litigious industry, then an investment bond may be used as a way of protecting your assets.
Investment bonds are a great alternative to superannuation, offering flexibility, control and access at any time. Below are the major differences between the two, in regard to these characteristics:
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Just like superannuation, you can nominate a beneficiary on your investment bond. By doing so, you can bypass the will and have the money paid directly to the beneficiary death. Investment bonds can also be paid out tax free if the life insured were to pass away, even if the 10-year window hasn’t been met.
By sitting outside of the will, the nomination can’t be challenged. This may be particularly useful if you have a blended family, want to leave money to a charity, want to leave money to a non-related party or friend or any other instance where you think your will might be challenged.
Case Study – Reducing taxable income (sourced from Generation Life)
Vivienne is a professional executive that currently earns $185,000 p.a.
She has $100K in a term deposit.
Vivienne would like to invest the full amount of her term deposit in a portfolio of investments which provides income and some capital growth over the long term.
Vivienne is considering investing in a managed fund but would like to ensure that her investment returns are as tax-effective as they can be.
Vivienne does not need access to the funds immediately, however she would like access to her funds at short notice if she did require them.
Vivienne invests a lump sum of $100,000 into an investment bond. She selects an Australian share investment option that is expected to provide an income return of 5.4% p.a. and capital growth of 1.5% p.a. over the long term.
By using an investment bond, Vivienne now has a tax-effective investment and retains access to her funds if an unexpected event occurs.
The investment bond’s tax rate (at a maximum of 30%) is considerably lower than her expected personal marginal tax rate of 47% (which includes the Medicare levy).
The tax arbitrage of 17% between her personal tax rate and the investment bond’s tax rate can provide a significant benefit that compounds over time.
Provided Vivienne’s investment bond remains fully invested for at least 10 years, she will not have to include any earnings from her investment in her tax return and will not have to pay any personal tax on her investment – or on any future withdrawals. If Vivienne did require access to her funds within 10 years of her investment, then Vivienne would be required to pay tax on the earnings component at her personal marginal tax rate, however, a compensating personal tax offset equivalent to 30% of the earnings would be available to her to reduce her tax liability. After 10 years, withdrawals are tax-free.