Why income bonds are making a comeback
In the rush to put money in superannuation, other investment vehicles with concessionary tax benefits have been overlooked. Income bonds have become one of the forgotten classes, writes Alison Massey.
Financial advisers in Australia are passionate about wealth creation for their clients. Whether it is to ensure enough is accumulated in the right structure in the lead-up to retirement, or to ensure that income can be drawn down in the most tax-effective way during retirement, the focus is firmly on the client’s needs.
Investors often compare investing in their own names to that of superannuation, as superannuation plays a large part in retirement savings and brings many benefits to investors; particularly the 15 per cent tax on earnings and transition to retirement benefits.
This emphasis on superannuation as a means to provide for retirement income is understandable when you consider the emphasis that is also put on retirement savings by governments, and how superannuation has become the main vehicle of choice to help investors achieve this.
However in the rush to superannuation, there are other investment products also with concessionary tax treatment that have largely been forgotten over the past decade.
One, which is experiencing resurgence, if the increase in associated queries received is anything to go by, is investment bonds, also known as insurance bonds.
Better than super?
In many ways, investment bonds are similar to superannuation funds: their earnings are taxed internally within the fund and they are taxed at the corporate tax rate (currently 30 per cent), rather than the top marginal tax rate (currently 46.5 per cent, including Medicare levy).
As an investment structure however, insurance bonds have some advantages over superannuation. Unlike superannuation, investors can access part or all of their funds at any time.
Money is not tied up until retirement and it comes with the added benefits of no annual personal tax liability and the earnings being free of personal tax if held for more than 10 years.
If access is required prior to 10 years, earnings are taxable; however investors receive a 30 per cent rebate for the tax that has already paid by the fund.
By way of example, consider the case of Ben:
- Currently 49, which gives him a preservation age of 60.
- Ben has been working as a fly-in, fly-out worker on the north-west shelf for the last five years.
- He has been dating for about 12 months. Although the financial rewards of his work are high, the demands of his prolonged absence contributed to the breakdown of his previous marriage and he is considering a change in employment to reduce the travel – he doesn’t think this will impact on his standard of living, but isn’t sure.
- A long-time goal has been to have the choice to retire at age 55.
- He has no personal debt and holds approximately $750,000 in super.
- Ben has just received an inheritance.
Ben might consider three choices to invest his inheritance:
- Superannuation – he gains access to the advantaged rate of 15 per cent on investment earnings. However, he forfeits the ability to access funds should he need to supplement income or to retire early.
- Personal name – he retains access to funds but as he is already in the top marginal tax bracket, with investment earnings currently taxed at 45 per cent plus levies.
- Insurance bond – he retains access to funds, pays no additional personal tax on investment earnings, as the tax is administered by the income bond issuer currently at 30 per cent.
Similar to superannuation, with an insurance bond there is no personal tax for the investor when switching between underlying investments within the fund, allowing flexibility when looking at strategic asset allocation. Importantly, investment bonds provide investors with similar managed funds and asset allocation options to that of superannuation or personal investments.
Investment bonds also provide opportunities when it comes to estate planning, as funds can pass directly, as a non-estate asset, to any personal or corporate beneficiary as a tax-free benefit.
This is in direct contrast to superannuation, which limits beneficiaries to dependants and has a variable tax treatment based on whether they are viewed as financially dependent or non-financially dependent.
In a live-in relationship?
Further analysing Ben’s situation, there are a number of factors to consider if Ben’s dating develops into a live-in relationship, and:
- He has two children from his previous marriage.
- His partner has two children.
- Ben has an ex-spouse. (In some states, an ex-spouse may be eligible to make a claim on his estate under a Family Provision Application).
- Ben is keen to ensure that he provides for his own children should he die.
What are the possible outcomes on Ben’s death?
- Superannuation – his children are eligible dependents; however whether any tax would be payable will be based on their age and degree of financial dependence.
- Personal name investments – can be left to any beneficiary; however distribution will be governed by the terms of Ben’s will and as such may be subject to a challenge. There is potentially an immediate tax consequence if an investment is realised by the estate.
- Insurance bonds – benefits are paid tax-free to beneficiaries and minimise contestability.
Long-term savings goals can be effectively met with investment bonds, perhaps more effectively in some cases, than they can in the superannuation environment.
It’s important to highlight that unlike superannuation, contributions are not capped with investment bonds, which creates opportunities when considering long-term savings goals.
In a world where financial planners are looking to add value to clients in many different ways, maximising the benefits to an investor across all investment options is a must.
Advisers regularly discuss life stages in terms of wealth accumulation, transitioning to retirement, pension phase and bequests for the next generation. Advisers should consider the availability of concessionary tax rates when undertaking this analysis.
Easing into retirement
To challenge conventional thinking, let’s consider the motives for clients choosing a path to retirement, and the different advice alternatives that are available to assist in achieving this.
The motives for creating wealth are different for all investors, but to broadly categorise they can often be condensed to three core needs:
- Facilitate lifestyle;
- Provide security; and
- Create a legacy.
The end goal for every investor is choice and control over their financial destinies – and being able to retire when they want and having the resources to live in comfort.
Superannuation has traditionally been the vehicle of choice to fund future needs; however it does come with a legislated requirement to preserve benefits until at least age 60.
To achieve unfettered access to superannuation benefits, investors also need to be no longer gainfully employed.
The long-term nature of superannuation – so essential for compounding returns to help ensure retirement needs can be met – is also one of its biggest drawbacks.
Government health and welfare budgets are under significant pressure and there has been on-going discussion about the possibility of the preservation age being extended, creating a mismatch between desired retirement age and fund access.
A rise in the superannuation age has been supported by a number of organisations.
The 2014-15 Federal Budget Submission from the Financial Services Council (FSC) proposes a two-year increase to age 62 which would reduce the retirement funding gap by approximately $421 billion or 18 per cent.
A rise to age 65 has an exponential impact with a reduction in the retirement funding gap of approximately 44 per cent.
The Grattan Institute’s 2012 Game Changers Report recommends raising the preservation age to 70, which arguably has a significant impact on Commonwealth Budgets through the combination of increased income tax revenue and reducing welfare payments.
While the Government is devising ways to improve the Budget bottom line and keep people in the workforce for longer, many investors have a different outcome in mind.
With the frantic pace of daily life, investors are expressing a desire to have the option to:
- retire – either in part or full; or
- enjoy a private sabbatical;
- prior to meeting superannuation access conditions.
To provide investors with certainty that they will be able to do so, or reduce their working hours when they want, we need to change our thinking about how to create retirement funding adequacy.
Where investment bonds work
The investment bond structure is a complementary addition to an investor’s retirement funding strategy for those:
- Wanting choice of retirement date.
- At or near their superannuation concessional contribution caps.
- Wanting to save without increasing their personal tax liability.
- Wishing to leave a non-contestable legacy to beneficiaries.
- Concerned about future risk of legislative change to superannuation.
Investment bonds provide a flexible and tax effective structure that holds no surprises.
Alison Massey is the national adviser solutions manager at Lifeplan.
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