Investment bonds: An education

As long as you wait 10 years you can withdraw the money from the bond and not pay any tax on the proceeds.

When you think of investment bonds, the first thing that comes to mind for most people is that they are a good long-term saving vehicle with tax benefits. For many there is also some vague association with education since they are often sold as special purpose funds for paying school fees.

Connecting the terms “tax efficient” and “investment bond” has been something the investment bond product manufacturers have worked tirelessly to do over the past 30 years.

But having never recommended investment bonds to my clients as they just never quite made sense to me, I thought it was time to finally take a look at them in detail and come to a conclusion for myself.

An investment bond is an interesting structure as it is a hangover from a bygone era where life insurance and savings products were tied together.

Popular back in the 1970s and 80s, life insurance companies offered insurance policies with both an insurance component and an investment component known as whole of life policies.

If you lived to age 65, the insurance policy would cancel and you would get a payout representing the investment component of the policy you had contributed to over the years.

The popularity of these policies waned overtime as it became obvious that it was more beneficial to take out a stand-alone life insurance policy at a lower cost and invest the difference into your own separately managed investment portfolio.

Although the whole of life policies are no longer offered in Australia, the investment component is still offered as an insurance bond, also known as an investment bond. You might say investment bonds are insurance policies without insurance benefits.

But there is, of course, an attraction. It works like this: there are special rules that apply to investment bonds that do not apply to other investment structures.

The most attractive is that you can invest money and as long as you wait 10 years you can withdraw the money from the bond and not pay any tax on the proceeds. Sounds great, a 10 year term to get tax free returns on bonds, property and share-based investments.

But that is not quite the full picture. The investment bond is taxed at 30 per cent on income and gains so when a withdrawal is made after 10 years, 30 per cent tax has already been paid on earnings and capital gains every year, and only the balance is paid out tax free. So, not so good, and not great at all if your marginal tax rate is less than 30 per cent.

You can invest up to 125 per cent of last year’s contributions and not upset the 10-year rule, but if you withdraw the bond early within the first eight years, you have to add all the income and gains to your personal tax return and pay tax at your marginal rate, less a 30 per cent offset. 

Limiting tax to 30 per cent sounds appealing, but just owning investments in your own name can produce a better outcome, even if you are taxed at the highest marginal tax rate of 47 per cent. If you sell an investment that you have owned personally for more than 12 months, you only have to include 50 per cent of the gain in your tax return.

In other words, the effective tax rate on capital gains tax for the highest income earners is only 23.5 per cent tax if the investment is held for at least 12 months. This is 6.5 per cent less compared to an investment bond which is not included in the discounted CGT rules.

And the tax benefit of investing personally rather than via an investment bond only gets bigger for those on lower incomes, or high income earners who wait until retirement to start selling down assets when their base taxable income is lower.

Another consideration is around the effect of compounding. The unit price of an investment bond will adjust downwards each year taking into account the 30 per cent tax on capital gains, which is a provision for the future capital gains tax payable at the end of 10 years. Whereas if you own an investment in your personal name, you only pay CGT when you sell the investment and lodge your tax return, with the benefit being more money invested earning more income and growth for longer.

Another potential issue with investment bonds are the fees. One of Australia’s largest investment bond providers charges 0.6 per cent base administration fee and then a fund manager cost on top depending on the chosen investment option (up to 1.5 per cent). The investment bond then needs to make 2.15 per cent just to break even if the most expensive fund option is chosen.

Thinking about right down the other end of the spectrum in terms of costs, an online share trading account can purchase a low cost ETF. You would pay a one off brokerage cost of $20-$30 and then around 0.15 per cent fee to the ETF provider each year which works out to be about 93 per cent cheaper than using an investment bond with their highest cost fund manager.

On balance, there are indeed some situations where an investment bond is useful. One is if you go bankrupt the money in the investment bond is protected from creditors provided you didn’t siphon money into the bond to avoid creditors.

Another is if you do not like paperwork as all the tax reporting is done internally with the bond so no hassles at tax time.

Another situation where they can be useful is for estate planning purposes. As the investment bond is an insurance product, the money you invest is actually classified as an insurance premium, and you can nominate children or grandchildren as the beneficiary of the policy which bypasses the estate and makes it simply to transfer a set amount of intended wealth from one generation to another.

In my opinion in most cases the disadvantages of investment bonds outweigh the benefits.

James Gerrard is principal and director of Sydney planning firm financialadviser.com.au