Loophole to save 11 per cent on tax through investing

Historically this tax saver “sucked” and was expensive. But that has all changed and now it’s an opportunity to get one up on your tax return.

In the current inflation and cost of living crisis, every dollar counts. And, if you want to not just keep up, but actually get ahead, you need to find a way to keep investing even while things are tight.

If you can find a way to make this happen, you’ll come through this period of disruption in a stronger position than you went into it – but it’s not easy.

Finding some spare money to invest is a challenge in itself. Then, once you invest as your investments build and grow you need to pay tax on your investment income on top of everything else.

But there’s one way to invest that delivers you some serious tax breaks, and at the same time gives a simple way to build your wealth into the future.

Enter investment bonds …

An investment bond is effectively an investment account that’s subject to some special rules and tax rates, sort of like superannuation but without the same restrictions on access.

Why investment bonds?

The big benefit of investment bonds is their tax efficiencies. With an investment bond, you can invest capital gains tax free for the long term, and all investment income (dividends) don’t get added to your tax return and so aren’t taxed at your marginal tax rate.

Investment bonds offer the opportunity to invest capital gains tax free for the long term. Picture: Unsplash

This significantly reduces the tax rate that applies to your investment income, and therefore increases your after tax investment return. The higher your after tax return, the faster you’ll get ahead – making more progress in less time.

Key rules of investment bonds

There are two main tax related rules and benefits of investment bonds. Firstly, when you hold the investment for 10 years or longer, capital gains tax doesn’t apply. This means any growth on your investments over the long term is received entirely tax free, rather than being subject to marginal tax rates of up to 47 per cent (discounted by 50 per cent for investments held for longer than 12 months).

The second benefit is that income like dividends and interest from investment bonds doesn’t get included on your tax return, and instead is taxed ‘internally’ by the fund at a maximum rate of 30 per cent. This rate is lower than marginal tax rates if your income is above $45,000, and gives a significant tax saving.

Interest from investment bonds doesn’t get included on your tax return. Picture: iStock

Upside of investment bonds

Investment bonds aren’t right for everyone, but if they do fit for you they can deliver some serious upside.

When you invest through an investment bond, as mentioned above the maximum rate of tax on investment income is 30 per cent, and there is no capital gains tax when you satisfy the ten year rule.

I wanted to unpack the numbers, comparing investing through one of these bonds against investing in your personal name.

Based on the long term Australian share market return of 9.8 per cent, broken down as 4.8 per cent income and 5 per cent growth, we can look at the after tax return on investment bonds as below.

Investment bonds:

Before tax income of 4.8 per cent, taxed at 30 per cent >> after tax income return: 3.36 per cent

Before tax growth return = after tax growth return: 5 per cent

Total after tax return = 8.36 per cent (total tax 1.44 per cent)

The implied tax rate here is 14.7 per cent (1.44 per cent/9.8 per cent)

Personal tax rate:

This compares to investments owned in your personal name as below, assuming a personal tax rate of 34.5 per cent (i.e. the tax rate that applies when your income is above $45k p.a.):

Before tax income of 4.8 per cent, taxed at 34.5 per cent >> after tax income return: 3.14 per cent

Before tax growth 5 per cent, taxed @marginal rate 34.5 per cent w. 50 per cent CGT discount = after tax growth return: 4.14 per cent

Total after tax return = 7.28 per cent (total tax 2.52 per cent)

The implied tax rate here is 25.7 per cent (2.52 per cent/9.8 per cent)

Based on the figures above, you can see that the tax rate on investing through investment bonds is a whopping 11 per cent higher compared to investing in your personal name. The extra 11 per cent goes straight to your bottom line, helping your investments to grow faster.

Worth noting that the above is based on a taxable income of $45,000 per annum, meaning that if your income (and tax rate) is higher, the benefits of bonds will be even greater.

Where did these bonds come from?

Investment bonds have been around for a long time, and I have to call out that historically they’ve sucked – they were expensive, didn’t have great investment options, and were really clunky with admin and paperwork.

But times have changed.

In recent years, with caps placed on superannuation, the ATO cracking down on trust investors, and with the development of more and better investment technology, investment bonds have been reborn.

Today they have sharp pricing, quality investment options, and a decent user experience to boot.

What are the risks?

Investment bonds are typically invested into the share market, so there will be ups and downs as the market moves. This means you generally shouldn’t invest money you might need in the short term, or you could be forced to sell investments when markets are down and suffer a loss.

Investment bonds are typically invested in the share market. Picture: iStock

Specifically with investment bonds, to access the main tax benefits you need to keep the money invested for the full ten year period, so this is definitely a long term play.

And last but definitely not least, your money is going to be put into investments – so if you choose bad investments you can lose money.

Worth noting these risks can be managed when you’re smart with your planning. Only using bonds when they fit in with your other money (and lifestyle) plans, and only using investments that consistently perform well over the long term.

The wrap

Tax is the silent killer, and is something most people don’t think about until after they do their tax return, but thinking ahead around your tax will pay serious dividends. Every dollar of tax you save is an extra dollar you can use to get ahead faster, or enjoy your lifestyle a little more.

Investment bonds aren’t for everyone, but if they do fit with your strategy they can deliver some serious benefits. They are complex, so if you’re going down this path make sure you understand the risks and consider getting some good advice – your focus on getting this right can make a huge difference to your bottom line not just today, but into the years ahead.

Ben Nash is a finance expert commentator, financial adviser and founder of Pivot Wealth, creator of the Smart Money Accelerator program author of ‘Replace your salary by Investing’ and the host of the Mo Money podcast. He runs regular free online money education events, which you can check out and book here

Disclaimer: The information contained in this article is general in nature and does not take into account your personal objectives, financial situation or needs. Therefore, you should consider whether the information is appropriate to your circumstances before acting on it, and where appropriate, seek professional advice from a finance professional.