With the severe cuts to superannuation tax breaks since July 1, the issue of where to invest outside the super system is back on the agenda for many investors.
To meet the new transfer balance cap of $1.6 million, some investors may have to withdraw money from their pension account and return it to accumulation mode or invest elsewhere.
The tax-effectiveness of investing outside of super may not be that great.
But other factors support it, such as the age of the investor, tax-free estate planning and the prospect of further caps on super contributions.
Investment bonds (also known as insurance bonds) have been around for a long time.
These insurance-like products have seen their popularity surpassed by the array of newer-style products on the back of the growth of super and self-managed super funds.
But investors should not ignore these older-style products which allow tax-effective wealth creation. Investment bonds require an upfront capital outlay, which is allocated to different asset classes.
Investors are also able to contribute to the investment over time. Tax on earnings is 30 per cent and is payable by the manager within the investment bond’s structure.
Crucially, holding the bond for 10 years leads to tax-free status in the hands of the investor.
The simplicity of the structure of investment bonds is a significant advantage as investors may be struggling to understand many newer, complex and costly investment products.
How they work
Investment bonds could be considered for the following reasons:
- Anyone can purchase: super contribution rules are not applicable as anyone can invest in an investment bond, whether they are working or retired.
- Small outlay: a low initial minimum investment of $1000.
- Capital can be withdrawn at any time, but if it is before the 10-year mark then earnings will be subject to the investor’s marginal tax rate. However, a 30 per cent tax offset (from the corporate tax paid by the issuer) is available on the withdrawn portion, which can be included in the investor’s tax return.
- Complementary to super: having reached the $1.6 million transfer balance, an investor can put the excess into investment bonds.
- Having reached the cap on annual concessional super contributions, investment bonds can be another long-term investment. Invest in a child’s name, until they reach 18 years old, to avoid paying the penalty tax rate applied to minors.
- Children’s education: invest for a particular purpose such as a child or grandchild’s education.
- Estate planning: by allowing benefits to be directed to a person without forming part of the deceased’s estate, which otherwise may attract a higher tax rate.
- Bankruptcy: investment bonds are mostly protected from the trustee in bankruptcy.
- Tax-effective: The investment bond’s earnings are not included in an investor’s tax return. The income of the investment bond is taxed at the corporate tax rate (currently 30 per cent) within the investment vehicle. The manager can use franking credits from investments to offset tax paid within the investment bond. And the investment is tax-free in the hands of the investor after 10 years.
- A broad range of investment options catering for different investment strategies and risk profiles are available.
What can go wrong?
Perhaps the most obvious flaw is the extended time investment bonds demand: a decade is a long time for any investor.
Investment Bonds issuers in Australia
|Australian Friendly Society
|National Australia Bank/MLC Group/TAL Group
Nonetheless, investors will be taxed if money is withdrawn early. If withdrawn within 10 years, a proportion of profits, which reduces depending on how long the investment has been held, will be taxed at the marginal tax rate, although with a tax offset available, as discussed above.
Separately, there are a number of issues any investors should understand.
- Contributions limit: if the investor contributes more than 125 per cent of the contribution made in the previous year, the excess will be subjected to income tax (with a tax offset), and a restarting of the “10-year rule” if the so-called “125 per cent rule” is breached.
- Returns depend on the manager: the success of the investment is dependent on the skill of the manager and market cycles.
- Fees: may include an entry fee, exit fee payable on early withdrawal, ongoing management fees and an advisory fee if acquired through a financial adviser. Fees affect long-term returns, so choosing products with lower fees may lead to a better outcome. Returns from investment bonds depend on the underlying investments, which are usually investment products offered by fund managers.
Insurance companies and bank-owned insurance providers issue investment bonds (See list at left). The main benefits are that your investment is likely to be capital gains-free after 10 years, the income does not have to be declared to the tax office during the 10 years, and yearly contributions are compounded.
The principles are similar to super but the investment bond can be cashed in early if needed (although there will be a tax on profits payable with a rebate).
In summary, these very traditional products, which have been left in the shade by superannuation