As the superannuation rules continue to change, investment vehicles like insurance bonds (also called investment bonds) are slowly but surely becoming more attractive from a tax perspective. This wealth pipeline provides a high-level summary of them.
1. What is an insurance bond?
Investment bonds are tax paid investment vehicles offered by life insurance companies (and friendly societies). This means when earnings on the investment are received by the insurance company, they are taxed at the corporate tax rate (currently 30%). This can make insurance bonds a tax effective long term investment for those with a marginal tax rate higher than 30%. Although it should be noted that as companies do not receive the 50% capital gains tax discount (CGT) that individual investors do, this may be a drawback from a tax perspective.
If you hold the bond for at least 10 years the returns on the entire investment, including additional contributions made, will be tax free subject to the 125% rule.
If you make a withdrawal within the first 10 years, the rate at which earnings in the investment bond are taxed will depend on when the withdrawal is made. See the below illustration:
2. The 125% rule
Investors in investment bonds can make additional contributions each year. As long as the contribution does not exceed 125% of the previous year’s contribution, it will be considered part of the initial investment. This means each additional contribution does not need to be invested for the full 10 years to receive the full tax benefits.
3. Benefits of investment bonds
- Can be a tax effective long term investment vehicle.
- Most offer a wide range of investment options to cater for different investment strategies and risk profiles.
- Many insurance bond providers nowadays allow investors to change their investment options throughout the life of the bond.
- Can be an effective way to save for a child’s future.
- Can be used as an estate planning tool – once the life insured passes away, the beneficiary receives the proceeds tax free.
- May be useful for people who are unable to contribute to superannuation.
4. Risks of investment bonds
- Fees will be applicable, and they will vary widely depending on the issuer of the investment bond and the investment options chosen.
- If you need to withdraw some of your money before the 10-year period is reached, some of the tax benefits gained may be lost.
5. Things to consider before taking on an investment bond
- Consider whether you are in it for the long haul, as the tax benefits from investment bonds are only realised if no withdrawals are made for 10 years and you comply with the 125% rule.
- Your ability to make regular contributions - these investments are particularly tax effective for people who make regular contributions over the life of the investment
- Consider the potential fees payable with this product - common fees you may pay include establishment fees, contribution fees, withdrawal fees, management fees, switching fees and adviser service fees.
Although we have focused on the tax aspects of insurance bonds they are an extremely useful estate planning tool. Technically, an insurance bond is a life insurance policy so they have nominated beneficiaries. This allows ownership to be transferred to a child when they reach a certain age. Possibly with the exception of NSW insurances bonds can bypass a Will which renders them an extremely useful estate planning tool.
As investment bond earnings don’t qualify for the 50% CGT discount arguably their underlying investments are best suited to high turnover strategies.