Investment bonds a tax-effective option

Investment bonds are often left off the products list, but they shouldn’t be. They’re not only flexible but they are also very tax effective.

Summary: Investors generally look to superannuation as the most tax-effective investment vehicle. But investment bonds are a good way of getting tax-effective returns outside of super, and they have multiple advantages.
Key take-out: As well as being useful to those who can no longer contribute to super, or who have reached their super contribution limit, capital put into investment bonds can be redeemed at any time. After 10 years capital can be withdrawn, generally tax-free, or can remain in the investment bond.
Key beneficiaries: General investors. Category: Fixed interest.

An investment vehicle outside superannuation

An investment outside of superannuation may not appear to be tax effective, but a lot can depend on the age of the investors, the cap on further superannuation contributions for high-income earners, and the need for tax-free estate planning.

Investment bonds, an insurance-like product which require an upfront investment that can be allocated to different asset classes and allow contributions throughout the life of the investment, provide a tax-effective solution – 30% tax is payable on returns within the investment bond structure and, if held for 10 years, are tax-free in the hands of the investor.

Indeed, investment bonds can assist investors, alongside superannuation, to meet long-term capital and income requirements. But investment bonds are an attractive solution for wealth management, not only because they are tax effective. Other positives that set them apart from other fixed term investments such as term deposits and annuities are the ability to contribute to the investment during its lifetime, the compounding of reinvested income, and the flexibility with respect to changing asset allocation during the investment period.

Another advantage is the simplicity of the structure. As recently highlighted in the financial system inquiry by David Murray, investment products are becoming too complex and costly. As a result, investors are less informed than they should be due to the difficulties in understanding the disclosure documents, and the costs of some products are becoming prohibitive.

Investment bonds have the benefit of a long history, having been around since the 1980s, and still retain their relatively uncomplicated terms. But their popularity may have declined due to the increased competition in the investment product space with products that are targeting superannuation funds or self-managed super funds

Investment bonds, alongside annuities which I discussed last week (Annuities – worth exploring), can provide some surety with respect to capital maintenance (in the case of investment bonds capital creation). Both are older-style investment vehicles, which seem to have been superseded by more recent offerings, but I think they deserve some consideration due to their traditional and well-tested characteristics.

Who should use investment bonds?

Also known as insurance bonds, investment bonds may be applicable to investors for reasons that include the following:

  • Unable to contribute to superannuation because no longer working;
  • Reached the cap on annual superannuation contributions;
  • Investing for a child in their name (but note that early redemption before the child reaches 18 years old may result in assessable income being taxed at the higher penalty tax rate of 45%);
  • Investing for their children’s (or grandchildren’s) education; or
  • Estate planning for beneficiaries – can be more tax effective than if held in superannuation.

What are investment bonds?

Issued by insurance companies (or the insurance subsidiaries of banks) and friendly societies, investment bonds are insurance products that are comparable to life insurance policies. But the primary benefit of investment bonds in current times is for creating a tax-effective store of wealth, especially if accessed after 10 years.

Although they must be held for 10 years or more to be tax-effective, there is flexibility in investment bonds in that funds can be withdrawn within 10 years, additional contributions can be made, and investors can choose the investment option they prefer – which usually includes the broad investment spectrum offered by fund managers.

The difference between investment bonds and most other investment vehicles is that there are no distributions to investors and any income is reinvested, where the benefits of compounding are realised to boost the value of the investment.

Benefits

  • Contribution rules do not apply: Anyone can invest in an insurance bond without meeting the contribution standard defined under superannuation, which restricts those that do not meet the work test, are not working a certain number hours after 65-years-old, and are over 75-years-old.
  • Minimum investment is low: Many investment bonds can be purchased for as little as $1,000.
  • Accessibility of capital: Capital is not subjected to the preservation rule of superannuation – the funds can be withdrawn within the 10-year period, and a 30% tax offset is available on the withdrawn portion, which needs to be included in a tax return. The “10-year rule” which is applicable means that after 10 years the capital can be withdrawn, generally tax-free, or can remain in the investment bond.
  • Estate planning: Death benefits are paid to the beneficiaries tax-free, while from superannuation the beneficiaries could be subjected to tax. Different beneficiaries can be nominated and the percentage for each beneficiary can be specified. In most states in Australia the benefits will not be included in the estate and therefore are not subjected to estate tax (see an accountant for advice).
  • Tax effectiveness: The investment bonds do not need to be included in the investor’s tax return. The income of the investment bond is taxed at the current 30% corporate tax rate, but this is done within the investment vehicle. Franking credits earned by the investments can be used by the manager of the investments to offset tax paid within the investment bond. And the investment is tax-free in the hands of the investor after 10 years, subject to meeting the 125% rule (defined below).
  • Broad range of investment options: The full stable of investment options are usually available including: cash, property, Australian shares and international shares, alongside capital stable, balanced and growth options.
  • Flexibility: The investor can change investments within the Investment bond without triggering capital gains tax.
  • Simplicity: No annual reporting unless there is an early withdrawal in the tax year.

Table 1 Tax payable if withdrawn early

Year

Tax outcome

8th year or earlier

100% of earnings assessed at individual’s marginal tax rate (MTR) less a tax offset of 30%

9th year

2/3 of earnings assessed at individual’s marginal tax rate less a tax offset of 30%

10th year

1/3 of earnings assessed at individual's marginal tax rate less a tax offset of 30%

After 10th year

No additional tax payable on earnings

Disadvantages:

  • 125% rule applies: The investor can only contribute 125% of the contribution made in the previous year and if more is contributed then the excess will be subjected to income tax (although as mentioned above, there is a 30% tax offset). There is also a re-starting of the “10-year rule” if the “125% rule” is breached.
  • Taxed if accessed early: If the capital or part-of is withdrawn within the 10 years, some of the profit has to be included as assessable income. How much will depend on how long the investment is held, as the amount reduces the longer the investment time period, reducing to zero after 10 years (see table 1).
  • Returns are subject to the fund managers’ expertise and market cycles: Like any managed fund vehicle the success will depend on the underlying managers’ ability to perform as well as the type of investment options chosen at the onset of the investment.
  • Fees: There may be an entry fee payable and/or exit fee payable on early withdrawal, and ongoing management fees are applicable (see table 2). An advisory fee also may be payable if acquired through a financial adviser.

Table 2 A selection of investment bonds

IssuerANZ OnePath Investment Savings BondCommInsure Investment Growth BondWestpac Foundation PlansIOOF Wealthbuilder Balanced FundKeyInvest Life Events Bond-Balanced
Initial Investment$1,000$1,000$1,0003 - 3,000$2,000$500
Entry Fee 0-4%003%3%
Exit FeeUp to 3% of any amount withdrawn within 3 years 0000
Management Fees41.30% (p.a.) to 2.66% (p.a.) depending on the fund0.85% (p.a.) to 1.5% (p.a.) depending on the fund1.39% p.a. to 1.7% p.a. depending on the fund1.50% (p.a.)1.88% (p.a.)
"Balanced" option returns p.a. over five years (net of management fees and taxes)53.99%16.98%25.35%7.67%7.11%
Notes:
1. Nil entry fee return, return of 4.56% with an entry fee
2. Returns for "Managed Fund" option (closed to new investors) as "Balanced" option has only one year of return
3.  $1,000 with a one month savings plan
4.  Other fees could be applicable for low balances or multiple switching between funds
5.  Past performance is not an indicator of future performance

Different types of investment bonds

There are various products available, with most of the insurance subsidiaries of the big four banks offering investment bonds, as well as other insurance providers. An investment bond can be capital guaranteed, investing in cash and other conservative investments, or unit linked, investing in managed funds. But the strategy chosen for the investment bonds, whether capital guaranteed options or more growth-orientated, should depend of the purpose of the investment bond.

An investor in the accumulation phase may consider a growth investment strategy with higher holdings in shares, while someone who has retired and focused on estate planning could invest a portion of their superannuation in an investment bond that is capital guaranteed. Although, outside of superannuation, the funds will be subjected to the 30% tax within the investment vehicle, nominated beneficiaries could receive the death benefits tax-free. This compares to being taxed in the hands of some beneficiaries if held inside superannuation.

Table 3 Investment bond issuers by funds under management

IssuerMar-14 ($m)Mar-13 ($m)Mar-12 ($m)
Australian Unity Group1,767.691,775.431,789.78
OnePath Australia Group888.78946.6982.31
Commonwealth / Colonial Group818.16798.65783.01
IOOF Group812.35770.58796.79
AMP Group519.5504.25523.96
Austock Life411.25327.22265.96
Centuria Capital365.14393.47429.2
National Australia / MLC Group276.02281.47298.96
TAL Group219.69219.28222.43
KeyInvest168.49165.3170.63
BT Financial Group135.85140.93147.75
Australian Friendly Society135.22124.58110.9
Suncorp Group89.76122.7126.93
ClearView Wealth Group30.3731.7633.93
HCF Life Group24.77
Grand Totals6,638.276,602.226,707.31
Source:  Plan For Life

Conclusion

Investment bonds provide a tax-paid investment, which is simple and flexible, and assists in long-term wealth creation and management.

Potential investors need to be aware of the fees applicable, as although the benefits of compounding exist – the impact of fees can offset some of the gains over time. The best option would be for a zero entry and exit fee (for early withdrawal) and a low ongoing management fee.

Investment bonds may not be the best choice for retirees, as superannuation and pension structures offer either lower or zero tax outcomes. But investment bonds are a good investment option for high-income earners who have reached the cap on their superannuation contributions, for estate planning and for investing for children.