Insurance bonds: tax appeal for a limited time only

Insurance bonds will remain an attractive investment vehicle for high income investors until at least the end of the next financial year. Michael Abbott explains their attraction and what happen on June 30 next year.

Insurance bonds will remain an attractive investment vehicle for high income investors until at least the end of the next financial year. Michael Abbott explains their attraction and what happen on June 30 next year.

Investors have until June 30, 2001 to take advantage of the attractive tax breaks offered by current generation investment bonds — after which their appeal looks set to wane.

Investment bonds became one of the key targets of the Ralph Business Tax Review, primarily because they offered people in the top tax bracket with an attractive investment vehicle for legitimately minimising tax.

While the future of these bonds is no longer quite so bright, there’s still a window of opportunity until the end of next financial year when new investors can reap rewards.

Up until now, investment bonds have been a fully tax-paid investment if cashed in after 10 years. Bonds taken out before July 1, 2001 should continue to be treated in the same way throughout their life span.

One of the key advantages of bonds for high-income earners is that their investment earnings are taxed each year at the company rate. For life insurers, this used to be 39 cents in the dollar but from July 1, 2000 the tax rate will become the standard company rate (ie 34 cents in 2000/2001, 30 cents in 2001/2002).

So rather than paying 48.5 cents tax on annual income — the top marginal tax rate including the Medicare levy — the investment pays a maximum of 30 cents from July 1, 2001.

What’s more, it is a hassle-free investment that is managed by professionals and, provided no withdrawals are made, looks after itself without any impact on your annual tax return or the new PAYG system that replaces provisional tax.

Likewise, the investor pays no capital gains tax if the bond is cashed in after 10 years. For high growth investments, the attractiveness of this feature has become less straightforward since the introduction of the Ralph changes to capital gains tax.

While individuals pay tax on half their capital gain, provided they hold on to the asset for more than a year (ie a maximum of 24.25 cents in the dollar), the bond will pay tax on the full capital gain at the company rate when the asset is sold.

Although the financial services industry is currently lobbying the government to extend the capital gains tax treatment for individuals to investment bonds, it has probably got only an outside chance. Regardless of the outcome, an individual may still come out in front by investing in an equity bond over a unit trust when the fund is actively managed and turns over stock quickly (ie wouldn’t meet the one year tenure condition anyway).

Likewise, investment bonds may be an excellent option for high-income earners who want to diversify their portfolio with a cash/fixed interest component, given they will pay tax at 30 cents in the dollar as opposed to 43.5 cents or 48.5 cents (the top tax rates plus Medicare).

For investments in balanced funds, bonds still come out at an advantage, from a tax point of view, in spite of their current capital gains tax treatment where more of the gain comes from income rather than growth.

Another highly attractive feature of current generation bonds is that each policy year you can top up your investment with up to 25 per cent more than you deposited the previous policy year without impacting on the tax treatment. So money added under this rule in year six, for example, receives the same tax treatment at maturity as if you deposited it in year one.

The 10-year rule will be abolished for new investment bonds taken out after June 30, 2001. From that time on, bond holders will have to pay tax on the income from the investment at their marginal rate either annually or at maturity, with a credit for the company tax already paid by the fund - similar to the way imputation credits work now.

The only major benefit from these future generation bonds will be if an investor wanted to defer tax until a time in the future when they will fall into a low marginal tax bracket. For example, if you planned to retire in five years time or take time out for family reasons, you could elect to pay tax on maturity. And unlike imputation credits, you may actually get a refund if the fund has paid tax at a rate higher than your personal rate.

And while current generation bonds pay out funds tax free if the policy holder dies — a key plus factor for estate planning - these future bonds will be taxed at the recipient’s marginal tax rate.

Michael Abbott is head of product management for Zurich Financial Services Australia.