Insurance bonds can break free of tax rules

After several years of discussions regarding proposals to change the taxation structure of insurance bonds, the Government has announced they will not proceed with any changes. Insurance bonds will continue to be taxed under the existing rules.

This is good news for many investors as the existing taxation structure and features of insurance bonds can provide strategic advantages for some investment portfolios, particularly for high income earners.

Insurance bonds are often overlooked and misunderstood.

Despite a wider range of underlying investment options, they have not been as popular as unit trust investments. The range of unit trusts continues to expand rapidly, while many fund managers have stopped offering insurance bonds to new investors.

Insurance bonds were in need of revamping, but the pending taxation changes would have brought the taxation in line with unit trusts and so it was considered not worthwhile spending time to develop and improve insurance bonds.

With a status quo on the taxation front, will we now see a reversal? Will fund managers recommence to offer insurance bonds? It is worth considering the implications of these investments and the strategic opportunities they provide to many investors.

Insurance bonds are ‘tax paid’ investments because the life company pays tax on the earnings before declaring returns. Tax is paid at the rate of 30 per cent.

Depending on the underlying assets of the bond, the actual tax rate that applies may be significantly lower due to the use of franking credits from shares and other allowable deductions.

Even though the 50 per cent capital gains tax discount does not apply to capital gains earned in the bond, these products can still be tax-effective, especially for high income earners, compared to a unit trust or fixed-interest investment.

Bonds held for 10 years or more can be cashed in without incurring personal income tax. If withdrawn after 10 years, no growth is included in the investor’s assessable income. Any withdrawal from the bond before the eighth anniversary will see the growth portion included as assessable income and taxed at the investor’s marginal tax rate.

If the withdrawal occurs between the eighth and ninth anniversary, two thirds of the growth is assessable income, and if withdrawn between the ninth and tenth anniversary, one third of the growth is assessable.

A rebate applies to the amount included in the individual’s tax return. The rebate is 30 per cent for withdrawals from July 1, 2002.

Owners of insurance bonds with a marginal tax rate lower than 30 per cent may benefit from redeeming their investment before the 10 years to take advantage of the rebate to offset tax payable on other income.

If the personal situation of a high-income earner changes, for example they stop working, they may also wish to consider redeeming their bond before the 10-year period is reached (see breakout panel for case study).

An insurance bond can also be used as a regular savings vehicle.

Additional amounts of up to 125 per cent of the previous year’s contributions can be invested each year without restarting the 10-year term. Importantly, the income earned in the bond is not distributed, so Pay-As-You-Go tax instalments (previously provisional tax) do not apply.

Owners of insurance bonds should not only consider taxation issues, but also the other advantages that they may provide such as:

They can be used for estate planning purposes because the proceeds are paid directly to specified beneficiaries on death of the life insured (if nominated), rather than passing through the will;

Assets can be protected from creditors in the case of bankruptcy, although strict rules govern this; and

Income is not added to the investor’s taxable income, so these investments can assist people who may be close to the threshold of $90,527 to avoid or minimise liability for the superannuation surcharge. If their income exceeds this threshold, superannuation surcharge may apply to some of the investor’s super contributions in the same financial year.

Insurance bonds provide simplicity for investment record keeping. Earnings are automatically reinvested in the bond, but reinvestment dates do not need to be tracked for capital gains tax purposes.

Insurance bonds are often compared to other managed investments in the marketplace, such as unit trusts. From a tax perspective, insurance bonds provide tax advantages for high-income earners while unit trusts may be more appropriate for low income earners.

However, the features of insurance bonds can create strategic advantages for these investments over unit trusts for all categories of investors. Individual needs and objectives should be assessed to determine the most appropriate option.

One point to note is that interest costs are not deductable for loans to invest in insurance bonds. If gearing is required, a unit trust should be used.

Jennifer Brookhouse is the technical manager for RetireInvest.