Investment bonds are promoted as tax-efficient investment solutions, particularly if investing on behalf of children. In this blog, I consider the advantages and disadvantages of these bonds and discuss alternative investment options for consideration. In short, we almost never recommend using investment bonds. Here’s why…
What is an investment bond?
An investment bond is a financial product that combines features of both life insurance and investments. They are typically issued by insurance companies. Investment bonds receive concessional tax treatments and allow you to nominate a beneficiary to receive the investment if they achieve a certain age or you pass away.
Many investment bond providers offer a broad investment menu including diversified index funds, which align with our low-cost, rules-based investment methodology. Investment earnings are automatically reinvested in the bond.
What tax advantages do they provide?
Investment income and realised capital gains within an investment bond are taxed at the corporate rate of 30%. However, the ultimate tax rate may be slightly less than 30% because of imputation credits. It’s important to note that earnings from the investment bond do not affect your individual tax situation. For those in the highest marginal tax bracket (47%), this arrangement could be beneficial.
If you hold onto the investment bond for 10 years or more, you won’t be required to pay any personal income tax, including Capital Gains Tax (CGT), upon withdrawing the funds. The 10-year timeframe commences from the moment you make your initial investment.
The ‘125% rule’ allows for regular contributions in the second and subsequent years without resetting the 10-year period. That is, investors can add up to 125% of the previous year’s contributions. However, if there is a lapse of one year without any contributions to your investment bond, you cannot resume contributions without resetting the 10-year period.
How much do they cost?
Providers of investment bonds typically charge an administration fee, typically falling within the range of 0.40% to 0.60% p.a., depending on the investment balance. Additionally, you will incur investment management fees based on your selected investment option. These fees generally align with what you would expect to pay outside of investment bonds. Therefore, the sole expense associated with using an investment bond is typically just the management fee.
Projected tax advantages versus cost
If I were to consider using an investment bond for my children’s funds, I’d likely use a low-cost, diversified index fund like the Vanguard High Growth Index Fund. However, a challenge with such diversified funds is that they generate more income and less capital growth. For instance, over the 10 years ending 31 December 2023, the Vanguard High Growth fund generated a total return of 8.7% p.a., comprising 6.05% p.a. of income and 2.65% p.a. of capital growth.
I calculated that if I invested $10,000 in January 2014 in an investment bond and withdrew the investment in January 2024, the total tax on investment returns over that 10-year period would be $1,790. The investment balance after tax would be $19,292, after subtracting the 0.60% per annum administration fee ($821).
By comparison, if the same investment were made in my personal name, and I were on the top marginal tax rate (47%), the total taxes paid would be $4,064. The investment balance would be $17,555, which is $1,737 or 9% lower.
Consequently, the tax benefits provided by the investment bond can outweigh the administration fees charged by the bond provider if the investor is subject to the highest rate of personal tax (47%). However, it is always important to explore whether there are better alternatives to investment bonds.
Alternative options to consider
Making investment decisions is most effective when you can refer back to a comprehensive, long-term financial plan. Without this contextual understanding, it becomes challenging to make financial decisions with a high level of certainty.
Park money in your home loan
Investors are drawn to investment bonds with the intention of saving for a specific purpose, such as children’s education expenses. However, this might not be the optimal strategy, especially for those with a home loan. Directing all available cash flow towards repaying the home loan quickly (as discussed here) could be more advantageous. This approach reduces debt which in turn increases future cash flow, offering risk-free (guaranteed) benefits, unlike investment returns, which are uncertain.
Invest in lower income earner’s name
If a spouse has a significantly low taxable income, it may be more advantageous to invest in their name rather than opting for an investment bond. This approach could potentially eliminate the need to pay any tax, and it helps sidestep investment bond administration fees.
Other ways to avoid CGT
The primary appeal of investment bonds is likely the avoidance from paying tax on capital gains after a 10-year period. However, it’s crucial to carefully consider when and how much of your portfolio you are likely to sell. For instance, many clients may not need to start selling investments until after retirement, when their taxable incomes are significantly lower. Additionally, they may not be selling substantial amounts and can strategically choose which investments and parcels to sell, which helps minimise CGT. Consequently, they may not end up paying a significant amount in CGT which negates the main rationale for using an investment bond.
Consolidate with your investments
Many of our clients invest in the share market on a monthly basis as part of their long-term plan to attain their financial goals, including funding school fees, for example.
It’s often unnecessary to designate investments for a specific purpose. Instead, we incorporate provisions for such expenses into the client’s comprehensive financial plan. This plan may involve investing through a family trust, providing flexibility to cover education costs, if necessary. However, it’s entirely plausible that clients can manage these expenses from cash flow, avoiding the need to sell investments.
The fundamental principle is to concentrate on building personal wealth in general. If you do that, it gives you the best chance of achieving your financial goals such as funding school fees.
Create their own account
Most share trading platforms offer accounts in a minor’s name, essentially functioning as an informal trust account. If you anticipate the child’s investment income will be below $416 p.a., I suggest providing the minor’s Tax File Number (TFN). In this case, if the investment income remains below $416 per annum, there’s no obligation to file a tax return.
However, if the investment income is expected to exceed $416 p.a., then use the Tax File Number of the lowest-income-earning adult. When your child turns 18, you have the option to transfer the holdings into their individual account without triggering any CGT. Subsequently, they can sell the shares, and if their income is low, they might not be liable to pay any tax on the capital gains.
We rarely recommend them
While investment bonds do have some good advantages, we rarely recommend them in practice. This is because there are usually more effective and flexible alternatives available, often at lower costs, to achieve our clients’ goals. These alternative solutions become particularly evident once we have a clear, holistic, long-term financial plan in place.