Investment bonds (sometimes call insurance bonds) were once a popular investment vehicle for high income earners. However, in the mid 1980’s along came superannuation, which soon became the investment of choice for many. Investment bonds are now undergoing a resurgence of sorts. And this is thanks to the restrictions on the amount that can be invested in superannuation. Below we have a look at the ins and outs of these slightly unusual investments.
What is an investment bond?
An investment bond is a ‘tax-paid’ investment issued by an insurance company on the life of an individual investor. Earnings on the investments are taxed in the hands of the life insurance company at a rate of 30% (or less, depending on deductions and franking credits etc.).
Being a ‘tax-paid’ vehicle can make investment bonds more attractive to those on higher taxable incomes or for those wishing to invest for children.
Some of the key benefits to investment bonds include:
- Simplicity – you are not required to report investment earnings in your tax return unless the bond is redeemed.
- Diversification – you can invest in a range of asset classes with varying investment risk.
- Investment choice – you can invest in a wide range of investments similar to a public offer super fund.
- Can be tax effective – the investment bond issuer pays tax on behalf of investors, which means that you as the investor don’t have to pay any additional tax as a result of the investment.
- Higher expected return than a Term Deposit.
- Liquid after maturity date – unlike superannuation which can only be accessed after you reach a certain age, investment bonds can be cashed in after 10 years of the original investment with Capital Gains Tax or preservation issues.
- Nominated beneficiary – similar to a life insurance policy, an investment bond can have a nominated beneficiary to receive the proceeds if you pass away. Payments are typically paid directly to the beneficiary and bypass your estate which can help provide estate planning certainty.
Things to look out for
Unlike superannuation where the same ‘contribution cap’ applies to all of us, there is no limit on the amount you can invest in the first investment year. Strangely though, there are limits on how much you can add in each subsequent year. This is commonly referred to as the ‘125 per cent rule’ and it works like this: after the first year, the maximum you can invest in any one year is 125 per cent of your investment in the previous year (without restarting the ten year tax period).
For example, if you invest $10,000 in the first year (based on the date you first invest in the bond), you are able to add up to $12,500 in the second year without re-setting the 10 year period. If you only invest $1,000 in the second year, then you are limited to a maximum of $1,250 contribution in the third year. The amount you can invest the following year is always based on the contributions in the previous year. The downside to this rule is that if you make no contributions in a given year you cannot add anything further to the bond without re-setting the 10-year period. Careful planning is therefore needed in this area.
Early Access Tax
If you need to withdraw the investment before the 10-year maturity date, you are required to include the assessable earnings of the investment in your personal tax return. This is not ideal as the bond has already paid tax of 30% on earnings each year and will then be asked to pay additional tax in the year you withdraw. (Note: a discount applies to withdrawals made in year 9 or 10).
Due to their increased complexity and low popularity, investment bonds typically have higher fees than their managed fund cousins. Be sure to understand the fees involved before you invest.
Investment bonds have a role to play. Given the exorbitant tax rate that applies to investing in children’s names (47% for unearned income over $416, for more detail see article on Investing for Children), investment bonds can be a smart option for long term investments such as education funding, planned gifts to children and estate planning.
We recommend seeking financial advice to see if investment bonds are suitable for you.
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Disclaimer: This post has been prepared for general information purposes only. It is not specific advice to any particular person. You should consult an authorised Align Financial adviser before making financial decisions. Align Financial | Financial Planner Northern Beaches | Servicing North Narrabeen, Narrabeen, Mona Vale, Elanora Heights, Newport, Avalon, Palm Beach | Enquire with us online