Wouldn’t it be awesome to have a long-term investment product offering tax benefits, a pool of investment options, and access to money at any time for any purpose?
Lucky for us, there is such a product called an investment bond.
Some investors call it a handy wealth management tool for tax asset protection and estate planning.
What is an investment bond?
Investment bonds are long-term investments that may be advantageous from a tax perspective for you if you have a high marginal tax rate and if you’re planning to save for your child’s education or future generations.
Just like superannuation, investment bonds are offered across several diverse investment options including shares, bonds, property, infrastructure, and mixed asset portfolios suitable to your investment objectives and risk tolerance.
Also, similar to superannuation, investment bonds combine a life insurance policy with an investment portfolio. Investment bonds are sometimes referred to as insurance bonds because they function similarly to a life insurance policy in terms of listing a policy owner and a life insured.
An investment bond is a tax-paid investment. It differs from other conventional investment vehicles, such as managed funds, as these are taxed on investment earnings paid by the investor.
As a tax-paid investment, earnings are taxed within the fund and aren’t part of your personal tax return. The bond issuer is responsible for paying income tax on interest and principal at a company tax rate of up to 30%.
So if your investment bond earns $10,000 and is taxed 30% or $3,000, your after-tax earning is $7,000. Whereas with a managed fund where you earn $10,000 with a marginal tax rate of 45%, your after-tax earning is $5,500.
| Investment Bond | Managed Fund | ||
| Investment earnings | $10,000 | Investment earnings | $10,000 |
| Tax paid by the bond manager | – $3,000 | Tax paid by the fund manager | 0 |
| Net return (at maturity) | $7,000 | Assessable income | $10,000 |
| Assessable income | 0 | Tax paid by the investor | – $4,500 |
| After-tax return | $7,000 | After-tax return | $5,500 |
| Disclaimer: This is solely for illustration purposes and should not be used as an endorsement or advice. | |||
An insurance bond may be a tax-effective structure for you to invest in if your marginal tax rate is above 30%. This means you have a chance to keep more of your investment earnings if you have a higher marginal tax rate than 30%. Particularly if you plan to keep your investment for ten years or more.
This is because you do not have to pay personal income tax on the investment ten years after the start date. As a result, as long as you don’t touch your investment for at least 10 years, you won’t have to pay any additional tax or capital gains tax.
10-Year Tax Rule
We mentioned earlier that investment bonds are long-term tax-paid investments with various investment options.
Switching between investment options is possible and doing so doesn’t incur capital gains tax (CGT) nor restart the investment bond’s 10-year tax period thus preserving its tax-paid status.
As a long-term tax-paid investment, your earnings on the entire investment including additional contributions will be free from CGT if you withdraw these after the investment bond’s 10th anniversary.
Meaning if you hold an investment bond for 10 years or more, its earnings need not be declared as part of your assessable income – it becomes tax exempt.
For any withdrawals you make before your investment bond’s 10th anniversary, you need to declare the earnings in your tax return. Even then, you get a tax offset of 30%; and you only pay tax on a fraction of the earnings if you withdraw cash on the 9th and 10th years.
| Period of Withdrawal | Tax Payable |
| Within 8 Years | All earnings are taxed at your marginal tax rate with a tax offset of 30% |
| During 9th Year | 2/3 of earnings are taxed at your marginal tax rate with a tax offset of 30% |
| During 10th Year | 1/3 of earnings are taxed at your marginal tax rate with a tax offset of 30% |
| After 10th Year | All earnings are tax-free |
It’s important to note that investment bonds enjoy a favourable tax status as long as your annual contributions do not exceed 125% of the prior year’s total bond purchases.
Understanding the 125% Rule
Before we tackle the 125% rule, let’s first discuss the investment year or policy year. Your first policy year begins on the day the investment bond is established, and each successive year begins one day before the anniversary date.
You can contribute an unlimited amount in addition to your original investment during the first policy year.
This means you can get started with a minimum amount of $1,000 and add as much as you want in the first year.
After the first year, you can invest up to 125% of your previous full year’s contributions without changing the initial start date for tax purposes.
The 125% rule permits you to make additional bond investments that are treated as part of the initial investment sum, thus not all additional bond investments need to be held for a minimum of 10 years in order for your returns to be treated as tax-paid.
Investment bonds offer a favourable tax status as long as your additional investments do not exceed 125% of the previous year’s contributions.
For example, if you invest $10,000 in year one, you can invest $12,500 (125% x 10,000) in year two, $15,625 (125% x $12,500) in year 3, and so forth. The amount of additional contributions will continue to increase until the end of the tenth anniversary, after which all withdrawals from the bond are tax-free.
| Bond Year | 125% of the Previous Year | Total Investment |
| 1 | $10,000 | |
| 2 | $12,500 | $22,500 |
| 3 | $15,625 | $38,125 |
| 4 | $19,531 | $57,656 |
| 5 | $24,414 | $82,070 |
| 6 | $30,517 | $112,587 |
| 7 | $38,147 | $150,734 |
| 8 | $47,684 | $198,418 |
| 9 | $59,605 | $258,023 |
| 10 | $74,506 | $332,529 |
| Disclaimer: This is solely for illustration purposes and should not be used as an endorsement or advice. | ||
Over 10 years, you contribute $332,529 but only $10,000 was invested for the full 10 years.
At the end of the 10-year term, you can withdraw your investment plus any increase or earnings tax-free. Or as an investor, you may opt to keep the investment bond open and continue to make additional contributions. These after-10-year term contributions are also tax-free upon withdrawal.
Using the 125% rule makes a bond investment, even more, tax effective because it allows you to make extra investments (or contributions to a savings plan) each year.
Please keep in mind that if you do not contribute to your investment bond in any given year, you will be unable to contribute in subsequent years because 125% of $0 is $0. You will need to either start a new investment bond or restart your 10-year period if you want to make further contributions.
Another thing to keep in mind is that if you contribute more than 125% of what you did the previous year to the investment bond, the 10-year period will be reset.
Now that we’ve clarified both the 10-year tax rule and the 125% rule on contributions, it’s time to discuss the pros and cons of investment bonds.
Benefits of an investment bond
As mentioned earlier, investment bonds are long-term investments that combine a life insurance policy with an investment portfolio and are taxed at an effective tax rate of up to 30%.
Now let’s break down these qualities and see how they can benefit you.
Tax Effective Alternative
An investment bond is a tax-effective alternative investment product because growth or income generated is exempt from personal income tax unless you withdraw the money within the first ten years. It’s also tax effective if you’re a high-income earner.
Transfer Ownership
Many investment bonds include a child advancement policy that allows investors to determine how soon the bond can be transferred into the child’s name. This can range from 10 to 25 years of age, and this can be done without incurring capital gains tax (CGT) or stamp duty.
Superannuation Supplement
Investment bonds, subject to the 125% rule, can be utilised by those who are unable to contribute more to their superannuation due to concessional and non-concessional contribution restrictions.
Flexible Access
Money can be withdrawn from the investment bond at any time should your financial situation change. While withdrawals in the first ten years are part of your assessable income, you can take advantage of the 30% tax offset.
Many Investment Options
Investment bonds are available in various investment options including fixed interest, shares, bonds, property, infrastructure, fixed income, and mixed asset portfolios that are appropriate for your investment objectives and risk tolerance.
You can switch between investment options free of CGT without disrupting the 10-year tax period on the investment bond.
Estate Planning Tool
Insurance bonds are practical estate planning tools. As a type of life insurance, the proceeds will be paid directly to designated beneficiaries in the event of the owner’s passing. The money can be disbursed swiftly and does not pass through the estate. Furthermore, even if the bond is less than 10 years old, the proceeds are not taxable in the hands of the beneficiaries.
Disadvantages of Investment bonds
The potential loss of principal is an inherent part of any investment. Your investment choices should reflect your objectives and risk tolerance. Keep in mind that an investment bond’s value could increase or decrease depending on the bond’s underlying investments.
Liquidity
If you take money out of the account before the 10 years are up, some or all of the profits form part of your assessable income and will be taxed at your personal income tax rate.
Fees and Performance
Investment bonds have high fees compared to other investment options, and they haven’t always done well in the past. Even though you may want to check the past performance of an investment product, do not that it is not indicative of future performance.
Additionally, investment bonds are considered passive investments, meaning you will not have direct influence over investment decisions and the bond fund’s performance.
Contributions
Certain investment bonds have a minimum balance that must be maintained, so it is critical to read the individual product description for further information.
If you provide more than 125% of your previous year’s contributions, the 10-year investment term will begin again, and if you fail to make an additional contribution in a certain year, you can no longer make additional contributions.
Capital Gains Tax (CGT)
The 50% CGT discount that people receive on assets they have owned for more than a year is not available to issuers of investment bonds. Instead, they pay taxes at the 30% company tax rate. The loss of any CGT discount is a drawback, and when investments are sold, the after-tax return rate may be lower.
Who should consider an investment bond?
Investment bonds are not for everyone. As mentioned earlier, an investor would have to be a high-income earner to take advantage of the 30% effective tax rate.
Additionally, one or more of the following qualities should be present.
Investors with a long-term investment horizon of at least 10 years may benefit from investment bonds.
Another group would be investors who have funds to spare and have made as many concessional contributions to superannuation as they possibly can.
Investors who do not need to access their funds because investment bonds reinvest dividends may find the hands-off structure of investment bonds attractive.
Lastly, parents or grandparents who want to invest on behalf of their children or grandchildren.
Are bonds a good investment for me?
So now we’ve come to the part where you might be thinking about getting an investment bond especially if you tick two or more of the investor quality boxes. However, you’re still not 100% sure if you should jump in with both feet.
There are two things you can do to get further information and help clarify things for you.
When financial service providers promote or provide a financial product, they must give you a product disclosure statement. It must include details about the product’s primary features, fees, commissions, benefits, risks, and the complaints handling procedure. You can check the product disclosure statement on the issuer’s website or ask a financial adviser for one.
A target market determination (TMD) is different from a product disclosure statement. A target market determination is a document required by the government that outlines the type of investor that would be interested in an investment product based on the investor’s needs, objectives, and financial situation.
The product disclosure statement and target market determination help investors and financial advisers alike if an investment bond is suitable. So before you fill up that application form, make sure to ask your financial adviser for both.
Explore Your Investment Bond Options with Coastal Advice Group
There are several reasons to consider investing in bonds, such as their tax efficiency, adaptability, diversification, and usefulness in estate planning. There are, however, costs involved and a lack of liquidity that must be considered.
If you have a long-term investment goal, a high income, or have maxed out your concessional superannuation contributions, investment bonds may be a good choice for you.
Before purchasing an investment bond, it is important to evaluate your goals, risk tolerance, and current financial situation. To do this, it may be advantageous to seek professional advice from a financial adviser.
While investing can seem complicated and time-consuming, it doesn’t have to be that way with knowledge and expert guidance. Whether you’re young or old, it’s never too late to start investing for your future.
Need investment advice? Coastal Advice Group is to help you tailor your investment plan and build your portfolio. Our financial advice team can help you establish direction for your investments to achieve your financial and lifestyle goals.
Call us or book online to secure your consultation today!
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