• Bill Savellis

Are Investment Bonds an Alternative to Superannuation?

The amount of money you are able to contribute to super has tightened in the last 10 years and, with a change of government expected this year, your ability to contribute to super is likely to get squeezed further.

If you would like to learn more about the proposed changes, refer to our article Labor’s Proposed Tax & Superannuation Policies.

So, this begs the question, is there a tax effective (and more flexible) alternative to superannuation?

One option to consider is investment bonds. With these ‘internally taxed’ investments, tax is paid by the provider at the company tax rate, which is currently 30%.

While this tax rate is higher than the 15% generally paid in super, it can be more attractive than paying tax at up to 47% on personally owned investments for people who are constrained by the total super balance, contribution caps and/or the restrictive access of superannuation.

In this article, we explain when and why investment bonds may be a suitable investment option. We also outline other key strategy considerations, as well as the tax and social security treatment.

Alternative to super

The ability and amount that can be contributed to superannuation for some clients is impacted by the:

  • Requirement to satisfy the work test if aged 65 to 74 and no contributions from age 75

  • Concessional contribution cap of $25,000 p.a.

  • Non-concessional contribution cap of $100,000 p.a. and bring forward rule which is subject to a total superannuation balance of $1.6 million, and

  • Transfer balance cap of $1.6 million limiting the amount that can be transferred to the retirement phase of superannuation.

These changes make it increasingly difficult for high income earners and high superannuation account balance holders to contribute to super in order to maximise their retirement savings.

Furthermore, the preservation rules, as well as the work test and restrictions that apply to the bring-forward rule for people aged 65 or over, make super more restrictive than other investment options. In these situations, investment bonds may provide a more tax-effective alternative to personally owned investments where earnings and gains are taxed at marginal rates of up to 47%, as the following table illustrates.

Other key strategy considerations

Investment bonds have no age restrictions when making contributions or making withdrawals. These also offer tax planning opportunities for lower income earners, estate planning opportunities and a range of other benefits.

Lower income earners

If a client’s marginal tax rate is less than 30%, they may benefit from cashing in all or part of a bond within the 10-year anniversary. This is because a 30% tax offset is available when a bond is cashed in and the growth portion is included in assessable income. As a result, bonds can be held tax-effectively in the name of a spouse or other family member who pays tax at a low marginal rate.

Estate planning

Investment bonds have some features similar to an ordinary life insurance policy in that there is a policy owner and a life insured. There can also be a nominated beneficiary. Like superannuation, the funds can be paid directly to certain beneficiaries and do not automatically form part of the estate. But, unlike super, there are no restrictions on who can be nominated as a beneficiary and the proceeds are received tax-free by all potential beneficiaries.

Children’s education

Young families may find it advantageous to invest in an insurance bond for the purposes of saving and funding education for their children or for their future financial needs. Some providers offer a child advancement policy where ownership of the policy can be transferred to a child when they reach a nominated age known as the ‘vesting age’, without any tax or duty implications.

It may also be possible for a minor aged 10 or more to be the owner of the policy. A child aged 16 or less would require the consent of their parent or guardian. Investing in an investment bond can be a tax-effective way to save for a child's future, considering the earnings would be taxed at the company rate, rather than at a higher personal marginal rate or at the penalty rate applied to unearned income of minors.

It could be beneficial for secondary or tertiary education, given the 10-year timeframe to receive proceeds tax-paid (see below). Also, if the child does not continue with further education, the proceeds can be used for another purpose (e.g. a deposit for a home).

Insurance bond held via a trust

Some clients may consider a discretionary trust as an option. However, trusts need to distribute income to avoid it being taxed in the hands of the trustee at the highest marginal tax rate.

An insurance bond could be used to manage the amount of income being derived in a trust. As the investment bond earnings are not income unless a withdrawal is made within the 10-year anniversary, no income will ordinarily be attributed to the trust.

This means there is no income from this investment to distribute to beneficiaries. This allows those earnings to be taxed within the bond at 30% rather than being distributed to beneficiaries with either a higher marginal tax rate or being taxed in the hands of the trustee.

Historically, this strategy was used to reduce the income for social security and aged care purposes. However legislative changes have resulted in a reduction in the benefit of this strategy for those clients.

Switching investment options

Unlike an investment in most managed funds, investment options can be changed at any time within the investment bond without triggering any personal tax implications. Where capital gains are realised in most managed funds, this may increase assessable income for the relevant financial year and impact a client’s eligibility for certain Government benefits and concessions or liability to pay levies. Examples include eligibility for the low-income tax offset, liability for HECS repayments or impact on Family Tax Benefits.

Bankruptcy protection

There is a potential protection advantage when it comes to bankruptcy. Investment bonds are protected from the trustee in bankruptcy if the life insured is the bankrupt individual or their spouse. However, transfers to an inestment bond that were made to defeat creditors may be available to the trustee in bankruptcy.

How investment bonds work

10-year rule

Withdrawals can generally be made at any time and no amount needs to be included in the investor’s tax return if the investment is held for 10-years or more. However, if they withdraw within the first 10-years, the accumulated bonuses are taxable as follows:

125% rule

Additional contributions can be made each year and will be considered part of the initial investment for tax purposes, if they don’t exceed 125%6 of the previous year's contributions. This means contributions that satisfy the 125% rule don’t need to be invested for the full 10-years to acquire the tax-paid status.

However, if the contributions exceed 125% of the previous year's investment, the 10-year period resets to the start of the year in which the excess contributions are made. Furthermore, if no contribution is made to the bond in any year, any contributions in the following years will reset the 10-year anniversary period.

Taxation of earnings

Earnings are taxed in the bond at the life company rate (currently 30%). Tax paid in the fund may be reduced by franking credits. The 50% CGT discount for investments held greater than 12 months is not available to life insurance companies and the full amount of capital gains realised in the fund is taxed at 30%.

Other withdrawal triggers

Tax-free withdrawals are allowed in some circumstances other than the completion of the 10-year period. These are when the bond:

  • Matures due to the death of insured person

  • Is surrendered due to an accident, illness or other disability of the insured person, or

  • Is surrendered due to severe financial hardship.

Social security and aged care treatment

Investment bonds are financial investments and subject to deeming under the income test. As such, entitlements to the benefits which are based on a definition of adjusted taxable income (e.g. family tax benefit) are not affected by these investments unless a withdrawal is made within the 10-year anniversary period.

However, if held through a trust, the private trusts rules will apply, and the value of the trust will be attributed either to the person who provided the source of the funds or the person who controls for assets test purposes. Under the income test, it is the income of the trust based on tax rules that will be attributed.

As an investment bond does not distribute income, there is no income assessment for social security purposes for trusts unless a withdrawal is made within the 10-year anniversary period.

Information published on this website has been prepared for general information purposes only and not as specific advice to any particular person. Any advice contained in this document is General Advice and does not take into account any person's particular investment objectives, financial situation and particular needs.

Before making an investment decision based on this advice you should consider, with or without the assistance of a qualified adviser, whether it is appropriate to your particular investment needs, objectives and financial circumstances. Past performance of financial products is no assurance of future performance.