Investment bonds remain a relatively niche product for Australian investors. However, this is not due to a lack of effort from those with vested interests.
In particular, some financial advisers have been highlighting their supposed benefits extensively on social media. The benefits being proposed are very attractive and may seem a no-brainer for a non-informed consumer of their content.
The issue is that these benefits are often vastly overstated by the investment bond companies themselves, along with a band of advisers repeating similar claims.
The benefit for an adviser recommending a client move to an investment bond is obvious. These companies make it ever so easy to set up an ongoing advice fee within the bond.
Coincidentally, these bonds need to be held for 10 years to realise their advertised benefits. 10 years of ongoing fees doesn’t sound so bad, does it?
Let’s dig into the supposed benefits of investment bonds and examine the generous overstatements from advisers and providers alike.
What are they?
Investment bonds, also known as insurance bonds, are a structure for investing money. The bond provider will have a list of options that you can choose from including Australian and international share funds, cash funds and fixed interest funds.
Investment bonds are known as a tax-paid investment. This means that in most cases they are internally taxed at a rate of 30% on all earnings with no impact on your personal income tax. The only time this isn’t the case is if you do not hold the bond for more than 10 years.
Withdrawing from the bond earlier than this may result in additional tax needing to be paid.
In addition to this restriction, investment bonds are also restricted by the amount of money that can be invested each year. The maximum amount you can contribute to the bond each year is set at 125% of the previous year’s contributions.
Another feature of an investment bond is that the ownership of these investments is separate from that of the beneficiary. For example, you could set up an investment bond and nominate another person as the eventual beneficiary (a grandchild for example).
One could imagine these features may benefit a large portion of the population. The most obvious being anyone paying a higher rate of income tax than 30%.
After all, if you pay more than this, the bond will cost you less in tax, right? Let’s focus on this and the other claims around tax efficiency.
Disputing the tax claims
The primary touted benefit of investment bonds is based upon the idea that 30% tax is much lower than many people’s marginal tax rates.
However, not all is at it seems.
Even on face value this statement is misleading. If we assume that the average salary of Australians is $100,000. At 24/25 FY tax rates, this person would have a marginal tax rate of 32%. This is hardly a huge difference that justifies the lack of flexibility of bonds.
It goes much deeper though.
Earnings mean capital gains and income
This definition is conveniently left out of the advertising by advisers and investment bond providers.
Investment bonds don’t differentiate between capital gains and income; all earnings are taxed annually at 30%, regardless of whether they come from growth or dividends.
Most investment bonds use a tax provisioning system, where funds are set aside to cover future tax liabilities rather than immediately paying the tax on all of the earnings. While this will delay the tax impact and allow more of your money to remain invested in the short term, the tax still needs to be paid and is deducted automatically by the bond provider with ultimately no control by you.
Loss of 50% capital gains tax discount
A pillar of the Australian taxation system is the idea of a capital gains tax discount for assets held longer than 12 months. To keep it simple, we could consider the long-term capital gains tax rate in Australia to be 50% of your marginal tax rate.
For example, the 32%, 39% and 47% marginal tax rates would become 16%, 19.5% and 23.5% respectively.
Even the highest marginal tax rate has a long-term capital gains tax rate lower than that of an investment bond.
Summary
The following points simplify why investment bonds are not as tax efficient as they’re made out to be:
- Investment bonds are taxed on their earnings at a flat rate of 30%.
- Earnings in this case means both income and capital gains that your investment makes.
- This means that you do not benefit from the 50% CGT discount, making the 30% tax on growth higher than that of any marginal tax rate if held for over 12 months.
The numbers
This means very little without looking at the numbers.
Let’s compare investing in your own name across different marginal tax rates (MTR) vs an example investment bond:
- 10 Year time period
- $10,000 initial investment
- 30% bond tax rate
- 5% annual growth*
- 3% income yield*
- CGT paid in final year for personal name
- Provisioned CGT paid in final year for bond
*These returns have been chosen to represent the estimated long-term returns of a high-growth blended portfolio.
For all but the higher MTR, the bond comes up short. Even if you are in the highest tax rate, is the lack of flexibility worth such a small gain?
But this projection isn’t accurate. Why?
Fees
Investment bonds aren’t free. In addition to the standard investment fee of the option you choose, most providers will charge an additional administration fee between 0.40% and 0.60% p.a. out of your account.
That’s not all. What’s one of the main routes into an investment bond? A financial adviser.
An adviser recommending a bond may wish to get paid too, via an ongoing fee also paid directly from your account.
Let’s run the projection again with these fees added in. The bond provider charging 0.40% and an adviser charging 0.80%.
A person in the 32% tax bracket could be more than 15% worse off by using an investment bond, rather than just investing in their own name.
The impact of the fees simply cannot be understated. By looking at it differently, it reinforces the point:
A 1.20% p.a. extra fee on an investment returning 8.00% annually could also be considered an extra 15% tax on those earnings.
Convinced yet?
So, investment bonds are useless?
No, there are certainly other potential benefits of investment bonds in areas such as estate planning and asset protection. Yet, these are mostly overlooked in many investment bond ads, in favour of talking about supposed tax benefits.
The tax benefits of bonds may start to show for investments with a higher weighting to income, provided that you’re in a high MTR. A strategy like this would be quite rare, as it would involve locking up funds for 10 years in a relatively low-earning investment like fixed interest.
There are just so many other ways of investing in a tax-efficient way without needing to use an investment bond; debt recycling, using super, utilising a discretionary trust.
Bonds claim to be tax efficient, yet how could they be when they remove the biggest tax break for investors, the 50% CGT discount? It cannot be understated how important this is for growing long-term wealth.
