By Pete Pennicott | March 2, 2020
With their origins dating back several decades when acid wash jeans and big hair were in fashion, investment bonds like some of this fashion are back in vogue. For years the shine wore off these misunderstood structures, as the new, younger, cooler structures became fashionable. More and more money flowed into superannuation, family trusts which also could deliver tax efficiencies and in many cases catered for the demand for more investment choice.
With constant tinkering by the Government of the super system, investment bonds like vinyl records are back in vogue and more popular than ever. Perhaps they were always cool and it might be more of a reflection of my lack of said cool-ness, but I digress!
I would encourage investors to add this to their due diligence when choosing an investment structure where tax effectiveness is needed. If you are under 45 years old, or perhaps looking to achieve an early retirement as a member of the FIRE movement (Financial Independence Retire Early) then read on.
Investment bonds offer another solution to tax effectively grow your wealth outside of the superannuation environment. The structure allows investors to build a portfolio, without increasing their personal income tax liability or even being taxed at their individual marginal tax rate.
Investment bonds (also known as insurance bonds or growth bonds) are technically life policies with an investment component. The investment component of an insurance bond is similar to the pooled investment
structure of a managed investment trust and shouldn’t be thought of as a traditional life insurance policy.
One of the main differences to a traditional managed investment is that as a life insurance policy, an insurance bond requires a policyholder (the investor), a life insured and allows for the nomination of beneficiaries. However, these are ultimately long term investments with specific rules and features that make them attractive to certain investors.
Investment bonds are internally taxed, meaning that earnings on the investment are taxed at the corporate tax rate (currently 30%) before being reinvested in the bond. This can make insurance bonds a tax-effective long term investment for those earning over $90,000 per annum with a marginal tax rate higher than 32.5%. It also suits those who have maxed out their superannuation caps or younger investors who want tax effectiveness but don’t want to lock up their money until preservation age.
Investors who are likely to be well suited for investment bonds include:
Due to the tax effectiveness and simplicity of management, investment bonds have a wide range of uses. They are particularly good for longer term savings towards know events that will occur 10 years or more into the future. The common ones that spring to mind are education costs, early retirement (when you are too young to get access to super), assisting children with first home deposits, investing on behalf of grandchildren and also when you have exceeded what you can get into super, just to name a few. There are a host of other strategies that they suit, one of the more impactful ones is estate planning, where is can assist to create certainty with respect to their wishes (especially when the funds are being left to minors).
While they are not for everyone, they deserve consideration as part of a broader strategy where superannuation is not the ideal solution for whatever reason.
Investment choice and the term of investment to achieve the maximum tax benefit, are the key considerations. Whilst they offer a diverse range of investment asset classes, there is generally far less investment choice within the solutions currently on the market. Also, from the tax perspective, the maximum tax effectiveness is reached after holding the investments for 10 years. The “10-year rule” means that if you hold the bond for at least 10 years, the returns on the investment will be tax free. So it isn’t really a strategy for short term investors.
Whilst investing for a 10-year term is ideal, investors don’t have to worry about locking the investment away for ten years either. One of the biggest myths surrounding investment bonds is that you have to invest for a minimum of 10 years. Consider this myth busted! The investment in an investment bond is accessible at any stage (barring frozen funds or other specific underlying investment anomalies). However, don’t get too excited as you should be making sure you are across the tax implications of accessing the funds before your 10 year investment anniversary. A quick summary table is below, but you really should to speak to your adviser to see how this impacts your personal situation.
The 125% rule:
This unique rule within investment bonds allows for investors to add to the investment each year. Providing these additions do not exceed 125% of the previous year’s contribution; it will be considered part of the initial investment. Why is this so good? Because it means that each of those additional investments does not need to be invested for the full ten years to receive the full tax benefits. Especially useful if you are making the most of this rule and adding up to this limit each year as part of a regular savings plan!
Caution: If contributions are made to the investment bond that exceed 125% of the previous year’s investment, the start date of the 10 year period will reset to the start of the investment year in which the excess contributions are made. You will then have to wait a further 10 years from this date to gain the full tax benefits.
Like any investment, your returns are only as good as the underlying investment selections. You will be selecting a professional manager, or mix of them to manage the investments on your behalf. Do your research and make sure it is appropriate for you.
By accessing any of your investment before the ten year anniversary, you will see a loss of some of the tax benefits.
Fees:
Like other managed funds, there are fees which apply to the investments, and they differ significantly between providers. Again, do your research and ensure you know what you are paying and that you are getting value for money.
As with any investment decision, make sure you do your own research as there are so many options out there.
Our experienced financial planners provide tailored strategies and guidance to suit your unique needs and financial goals. If you’re seeking expert investment advice, reach out to a Pekada financial planner today.
Pete is the Co-Founder, Principal Adviser and oversees the investment committee for Pekada. He has over 18 years of experience as a financial planner. Based in Melbourne, Pete is on a mission to help everyday Australians achieve financial independence and the lifestyle they dream of. Pete has been featured in Australian Financial Review, Money Magazine, Super Guide, Domain, American Express and Nest Egg. His qualifications include a Masters of Commerce (Financial Planning), SMSF Association SMSF Specialist Advisor™ (SSA) and Certified Investment Management Analyst® (CIMA®).