Investment bonds are often considered an old fashioned investment option, and as a savings vehicle they can be overlooked by financial advisers and their clients. But the reality is that investment bonds have a number of advantages that make them well worth a closer look.
If you were to develop, from scratch, a flexible, tax-advantaged investment that would help Australians build up their wealth outside their superannuation and enable the smooth transition of wealth across generations, you would be hard pressed to come up with a better option than an investment bond.
An investment bond is a tax-advantaged, simple and flexible savings vehicle that pools an investor’s money in a similar fashion to a managed fund, to help them grow their savings over time.
As with a managed fund, an investment bond is a good option for those saving for long-term financial goals. These bonds benefit from a distinctive tax treatment that can be particularly useful for advisers and their clients.
An investment bond is a great way to save for a large purchase – such as a house – or to supplement retirement savings as a more flexible alternative to superannuation, assist in estate planning and intergenerational wealth transfer, invest on behalf of children, ensure you are covering your funeral expenses in a way that won’t impact your social security entitlements, or simply invest tax effectively.
TAX-EFFECTIVE INVESTING
There are many benefits of investment bonds – not least their tax benefits. Investors pay no personal tax on investment earnings while their money is in the investment bond. Plus, any withdrawals made after 10 years are tax-free, subject to what is known as the 125% Contribution Rule.
Under the 125% Contribution Rule, the contribution amount in the first year of the investment bond is uncapped. However, from the second bond year onwards, contributions cannot exceed 125% of the previous year’s contributions, each year. Withdrawals made before 10 years will be taxable, but may receive a tax offset for tax already paid in the fund. This is because the investment bond pays tax on investment earnings at the business tax rate of 30%.
While they are invested in the investment bond, investors do not need to record investment earnings on their personal income tax returns.
Investors typically choose to invest an amount upfront, in addition to frequent contributions during the period the bond is held, depending on their personal savings goals and investment objectives.
Investors and their advisers can choose from a range of investment options, from conservative to growth as well as the option to invest sustainably, in the same way as they can with a managed fund.
A COMPLEMENT TO ESTATE PLANNING
An investment bond is also a useful estate planning tool, and can be a good way to help plan for the distribution of an estate. This makes it a particularly attractive option for blended families. An investment bond can effectively complement a Will to enable the smooth transition of wealth across generations.
Many people find setting up legal structures in a Will, such as testamentary trusts, a complex and sometimes confronting process. However, setting up an investment bond as a way of leaving a lump sum to beneficiaries is much more straight-forward.
Clients can nominate beneficiaries anytime to receive the proceeds of the investment bond in the event of their death—tax free—without the hassle of a probate or the concern that the estate may be potentially contested. No yearly renewal is required, and the nominated beneficiaries can be updated at any time.
Naming beneficiaries in the investment bond means there is no disputing your intentions and the investment will be distributed to nominated loved ones, tax free, without delay.
Additional contributions can also be made year by year on behalf of the beneficiary if an ongoing plan is established.
An investment bond is also an option for those looking to invest for their children or grandchildren as it allows for the simple transfer of wealth between generations, tax free.
Ordinarily, any investment held in the name of a minor is taxed at the highest marginal tax rate. However as the tax on an investment bond’s earnings is paid within the fund, a child does not need to declare the income from their bond on their personal tax return.
Further, when a nominated child reaches an age of your choosing, there is no capital gains tax paid on the transfer of the policy. Additionally, the start date of the 10-year rule remains from the start of the policy, so the child is closer to tax-free withdrawals from the fund.
Once the child receives the money, they can spend it however they like, with no further restrictions on its use.
A TAX-EFFECTIVE SUPERANNUATION ALTERNATIVE
As a result of their heritage in the friendly society space, investment bonds have the unique advantage of offering a lower tax rate than almost any other investment option, outside of superannuation.
But unlike superannuation, an investment bond has no limits on how much—or how often—investors can contribute to their investment, providing they meet the 125% Contribution Rule. What’s more, they can access their funds at any time. And by meeting the 125% Contribution Rule, the investment income will become tax-free after 10 years.
For people who have reached their superannuation contribution limits but have additional funds that they would like to save for their retirement, investment bonds offer a flexible tax advantaged approach.
Because investment bonds have a maximum tax rate of 30% on earnings in the bond, it is also very tax-effective option for people on a higher personal tax rate. Furthermore, investors do not have to pay any personal tax on the money invested or the interest while funds remain invested.
If the bond is held for 10 years or more, any withdrawals are not liable for personal income tax and are not required to be included in tax returns.
For those concerned about locking their money away in superannuation, investment bonds have the further advantage of allowing people the flexibility to access the funds whenever they wish.
FUNERAL BONDS
A funeral bond is a type of investment bond that is specifically designed to help pay for future funeral expenses. It allows clients to save for the costs of a funeral over time. Like all investment bonds, the tax paid on the income earned is paid within the bond, so clients do not need to declare any income earned on their investment.
Because a funeral bond investment is specifically designed to contribute towards future funeral expenses, funeral bond savings are set aside to cover the funeral costs and the investment proceeds can only be accessed at the time of death. There are special measures in place to ensure that the money invested is only used for the funeral service, helping to ease the financial burden that would otherwise be faced by family and providing them with peace of mind.
Any excess funds remaining after payment of the funeral expenses are either paid to the deceased’s estate or back to the investor if the bond has been taken out by an investor on another person’s life.
MAXIMISING AGED PENSION ENTITLEMENTS
Funeral bonds are designed to be exempt for the purposes of the assets test, income test and deeming provisions including the Age Pension, Carer Payment or Disability Support Pension – up to what is called the Funeral Bond Allowable Limit.
The Funeral Bond Allowable Limit as at 1 July, 2021 is $13,500, and it is indexed in line with CPI pension increases every 1 July.
The Funeral Bond Allowable Limit applies to the total contribution you have invested in the Bond, net of fees and increases in value of the Bond over time. To satisfy the requirements of this legislation, the investment must be kept solely to contribute towards funeral expenses, must be a reasonable estimate of the cost of the expenses, and cannot be withdrawn prior to death.
Considering the cost of funerals in Australia, this can be a good investment option. The ASIC MoneySmart website says private funerals typically cost somewhere in the region of $4,000 for a basic cremation up to $15,000 for a more elaborate burial. No small costs to be faced by families on the death of a family member.
It is clear there are many benefits of investment bonds that may be overlooked by financial advisers and that it is a vehicle that can provide a valuable tax effective option.
As far as regular savings plans are concerned, the advantages of an investment bond are hard to beat. Advisers and their clients can typically choose to invest an amount upfront and also make regular additional contributions over time, secure in the knowledge that their investment had been made in a tax advantaged environment.
Emma Sakellaris is chief executive of Foresters Financial.
