An alternative to superannuation

Insurance bonds are undergoing something of a renaissance, writes Sarina Raffo. She explains the benefits they offer clients.

Insurance bonds were a popular investment in the 1980s, and they are currently enjoying renewed interest — possibly due to an ever-changing landscape, and the perceived complexity and limitations of superannuation.

An insurance bond can complement superannuation investment or even be an alternative to superannuation in your clients’ investment portfolios. They can also be appealing from a taxation, estate planning and Centrelink perspective.

An insurance bond is a type of managed fund offered by insurance companies. It comprises a life insurance policy with both an investment and an insurance component.

Insurance bonds have traditionally been recommended for high-income earners who are looking for tax-effective investments.

They are also commonly used for education funds for children or grandchildren. However, they can also be an alternative to superannuation. In this article, we will look at situations where an insurance bond may be preferable to superannuation.

Contribution rules

Both superannuation and insurance bonds are subject to contribution rules.

Superannuation

Anyone under age 65 can contribute to superannuation, however some funds may impose restrictions on minors opening superannuation accounts. A work test must be satisfied between age 65 and 75. There are also limits on the amount of concessionally taxed contributions that can be made.

Insurance bonds

An individual must be age 16 to take out an insurance bond in their own name, but there is no maximum age. Parents and grandparents can own a bond for the benefit of a minor.

There is no limit on the initial investment amount in an insurance bond. Subsequent contributions to an insurance bond are limited to 125 per cent of the previous year’s investment amount. Exceeding the 125 per cent amount, or stopping and then resuming annual investments, restarts the 10-year tax-free period.

An insurance bond may be a good option for individuals who are unable to meet the work test or are over age 75 or under age 16. Similarly, an insurance bond may be appropriate where an individual has exceeded their superannuation contribution limits.

Taxation

Super

While nothing can beat superannuation in terms of overall tax efficiency, insurance bonds can also offer significant tax benefits and, importantly, simplicity.

Concessional superannuation contributions are subject to 15 per cent contributions tax upon entry to the fund. Investment earnings are taxed at 15 per cent and this tax is paid by the fund (not by the member).

Individuals on marginal tax rates of 37 per cent (over $80,000 per annum) and 45 per cent (over $180,000 per annum) can make a tax saving of 22 per cent or 30 per cent.

Most tax is effectively deferred until withdrawal of benefits from the superannuation environment. Benefit payments prior to age 60 are concessionally taxed and are tax-free from age 60.

Insurance bonds

The investor does not receive the earnings generated by insurance bonds as income. Instead, the earnings are reinvested.

They are only taxable upon withdrawal prior to the first 10 years and are tax-paid on or after 10 years. Insurance bond income is taxed internally within the bond at a rate of 30 per cent (this may be lower if franking credits and other tax offsets apply).

Investments made after the first year under the 125 per cent rule do not need to be invested for the full 10 years for the earnings to be tax-free.

Additional tax is only payable by the investor if a withdrawal is made within 10 years of the investment. Investors receive a 30 per cent tax offset on the assessable portion of any withdrawal. Individuals on lower tax rates can apply the offset to reduce tax on other income.

All the investment income from a withdrawal in the eighth year is included in assessable income and taxed at the investor’s marginal tax rate.

Two-thirds of the investment income is included in assessable income in the ninth year, and one-third of the investment income is included in assessable income in the tenth year.

Insurance bonds offer an obvious tax advantage for higher income earners. Individuals on marginal tax rates of 37 per cent and 45 per cent can make a tax saving of 7 per cent or 15 per cent.

However, the tax savings available through super investment are higher.

Access to funds

Superannuation

Superannuation is generally preserved until retirement from the workforce after preservation age (55-60).

Superannuation can be drawn down as an income stream whereas withdrawals from an investment bond can only be in the form of a lump sum.

A person’s age determines the minimum drawdown from a superannuation income stream. For example, a person under age 65 must draw down 4 per cent (2 per cent in 2010-11) of their account balance each year.

Insurance bonds

Insurance bonds can overcome the main drawback of superannuation: preservation. Part or all of an investment in an insurance bond can be withdrawn at any time (subject to any minimum balance requirement).

However, the tax implications should be considered if withdrawals are made before 10 years.

Centrelink treatment

An insurance bond can have an advantage over superannuation for some income-test sensitive clients.

Structuring an insurance bond in a private trust can potentially increase Centrelink benefits under the income test and may also reduce aged care costs.

An insurance bond held within a discretionary trust will not generally produce taxable (and therefore Centrelink assessable) income. Income is only assessed based on the amount distributed to trust beneficiaries.

An insurance bond (outside a trust) is classified as a ‘financial investment’ for Centrelink purposes and is therefore fully assets tested and subject to deeming. Superannuation only counts as an asset and is deemed from age pension age.

Estate planning

From an estate planning perspective, insurance bonds can be superior to superannuation where a client’s only beneficiaries are non-dependants (eg, adult children or parents).

Superannuation rules restrict who can receive a death benefit, and tax law restricts who can receive death benefits tax-free. An insurance bond can overcome these limitations as they allow the proceeds to be paid tax-free to any beneficiary (including non-dependants).

Multiple beneficiaries can be nominated on an insurance bond and this ensures that the proceeds will go directly to the person(s) nominated and bypass the estate.

This can be particularly important in the case of separated/divorced parents.

It also means the proceeds cannot be subject to challenge by disaffected family members. An insurance bond, being a life insurance policy, can also provide protection for bankrupts against claims by creditors.

Savings for children

Superannuation may not be an appropriate vehicle for saving for children/grandchildren due to access issues.

In contrast, insurance bonds can be an excellent savings vehicle for children. They can be set up as advancement policies with ownership transferring (generally free of capital gains tax) to a child or grandchild at a predetermined age.

Switching ownership does not reset the original purchase date in regard to the 10-year tax rule.

Insurance bonds provide a tax-advantaged environment for minors as the tax treatment for a minor is the same as that for an adult.

By investing in an insurance bond, penalty tax rates normally applied to a minor’s investment income can be avoided.

Simplicity

Insurance bond income need not be declared in tax returns and is not included in the investor’s assessable income. This may therefore reduce Medicare levy and allow the investor to qualify for tax offsets and family tax benefits.

While there are some key rules around insurance bonds, they are not nearly as complex as superannuation rules and investors are less likely to be subject to legislative risk.

Conclusion

The features of insurance bonds such as their tax, estate planning and Centrelink benefits make them a valuable strategic tool in financial planning and a real alternative to superannuation for some clients.

While superannuation is seen as a superior savings vehicle, insurance bonds may be more appropriate for those affected by contribution rules and limits or preservation issues.

Insurance bonds can also be attractive to a wide range of people including those on higher marginal tax rates, those who wish to avoid the complexity of including bond earnings in their tax returns and those who receive a large windfall (eg, recipients of an inheritance, a lottery win or a redundancy payout).

Sarina Raffo is a technical services consultant at Suncorp Life.