Before we begin, investment bonds are different from bonds. Bonds are an investment where you loan your money out. Investment bonds are an investment vehicle or legal structure like managed funds, LICs, or superannuation, which holds investments such as stocks, bonds, etc. Investment bonds are offered by insurance companies/friendly societies.
They are marketed as having no personal tax to pay if you don’t withdraw until after 10 years. The reality is that it is tax-paid, meaning that tax is paid within the bond. If you had to pay personal tax on top, you would be paying tax twice.
Investment bonds, also known as insurance bonds, are actually life insurance policies – minus the insurance part.
A bit of history
There are four types of life insurance in Australia – term life, TPD, trauma, and income protection.
They are all pure life insurance products, meaning there is no investment combined with it. You only pay for the part that pays out in the case of illness, injury, or death. Otherwise, you get nothing back. Premiums are much lower to reflect this.
However, once upon a time in Australia (and still in many other countries today), an insurance product called whole-of-life insurance combined insurance with investment. They are generally opaque – you don’t know how much of your investment is used to pay for the premiums, or how much you pay in fees for the investments. They are invested conservatively to preserve the funds in there, which results in low returns and is a massive drag on returns over the long term. The main benefit is that there is generally always money available for the insurance premiums, so premiums can’t accidentally lapse and leave you uncovered. And for those who otherwise would never have invested any money, they would have some money regularly set aside for later in life, although this last point has been replaced by super.
If you read investing and personal finance websites from the US, where these are still offered, any time you read of someone saying to avoid some terrible insurance product, it’s pretty much always whole-of-life insurance.
Since the ’70s, whole-of-life insurance in Australia has steadily disappeared, although legacy whole-of-life insurance policies still exist. Whole-of-life insurance in Australia has been separated into more flexible and transparent pure insurance and investment products. The investment part is investment bonds (or insurance bonds).
The tax benefits effects of investment bonds
Investment bonds are marketed as a tax-efficient investment because no tax is payable by the individual (provided it is held for at least ten years). It is internally taxed at the corporate tax rate of 30%. It sounds like a fantastic tax-advantaged investment vehicle for anyone with a marginal tax rate over 30% and investing for the long term (over ten years).
Let’s take a closer look.
Shares are one of the most tax-effective investments available. Two reasons for this are:
- The 50% CGT discount
If an individual has held shares for more than 12 months before selling, 50% is taken off their capital gain before adding it to their income tax return.
- The ability to delay paying tax and sell down when on a lower marginal tax rate
You do not pay tax on capital gains until the shares are sold, and far less tax can be paid by waiting to sell until retirement when you are on a much lower marginal tax rate.
These benefits are lost when using investment bonds.
1. Losing the 50% CGT discount
The 50% CGT discount can be used by individuals but not by companies. Provided shares are held for longer than 12 months, a person on the highest marginal tax rate of 47% (including Medicare levy) would have capital gains taxed at 23.5% in their own name compared to the company tax rate of 30% within an investment bond. And that is for the top 5% of the population on the highest marginal tax rate. Losing the 50% CGT discount and paying 30% tax has an even bigger negative impact the lower your marginal tax rate.
2. Losing the ability to delay tax paid and sell down when on a lower marginal tax rate
Since everything is taxed at 30% within the bond, you cannot take advantage of waiting to sell down when you are on a lower marginal tax rate. Although you may be able to lessen the downside of investment bonds somewhat by redeeming them early if you meet a specific set of circumstances.
An earlier version of this article stated that due to the tax provisioning requirements of investment bonds, tax is paid on capital gains each year, losing the ability to compound capital gains until it is redeemed. This does not appear to be correct, so it has been removed. Provisioning is merely numbers in the accounting ledger.
What about the income component of investments in investment bonds?
Yes, there is an advantage with the income component of investments within investment bonds while you are on a marginal tax rate over 30% because the benefits of shares mentioned above do not apply to income. But selecting tax-inefficient investments just so that they can be a bit less tax-inefficient (but still tax-inefficient) doesn’t make sense.
And whilst investment bonds are cheaper than they previously were, they’re generally more expensive than other investment avenues such as direct investment or even superannuation. With defensive assets generally having lower returns, the additional fee can pretty quickly negate any potential tax saving.
For long term investing, you want the majority of your investments in tax-effective growth assets due to the 50% CGT discount, the ability to earn and compound returns on delayed tax payable, and the ability to sell down when you are on a low marginal tax rate. However, the higher the capital growth component to make use of these advantages, the worse investment bonds perform.
The article below is one of the better ones, showing an apples-to-apples comparison that you’re worse off tax-wise with an investment bond unless you are on the highest marginal tax rate. If you select investments with a lower capital gain component, the investment bond nudges slightly ahead for someone on the second-highest marginal rate, but as mentioned above, it doesn’t make sense to use lower growth products.
But these numbers are all theoretical!
Many analyses (such as in the one linked above) use theoretical numbers and approximations, which come up with similar negative results for investment bonds. But with approximate numbers used in theoretical scenarios, investment bond providers can (rightfully) claim that the assumptions and nominal return figures used in the analysis are not realistic, so the results can be taken with a grain of salt.
If we are using real world numbers that show how poor investment bond returns are, there is no longer any argument.
Thanks to ghostdunks for doing just that in the following post.
Investment bonds have high fees. If you take a look at the largest provider in Australia, GenLife, they have a 0.60% fee  on top of the investment fee. A significant drag on returns.
If you were to buy an Australian index fund or a global index fund (e.g. VAS or IWLD), you would be paying 0.10% of your assets per annum in fees.
If you bought the same product through GenLife, for instance iShares Australian Equity Index Fund or iShares Wholesale International Equity Index Fund, the cost is a whopping 0.70% of your assets per annum.
Let’s take a look at what you get over ten and twenty years based only on the higher investment fee. This ignores all the lost tax advantages mentioned above.
As you can see, over ten years, there is a 117% gain vs a 131% gain, so 14% of the initial investment has been lost in returns due entirely to the higher fee.
Over 20 years, a whopping 55% of the initial investment has been lost in returns due to fees alone. This is in addition to the tax issues mentioned above.
Besides the tax-related downsides for anyone other than those on the highest marginal tax rate (or for a couple, where both are on the highest marginal tax rate), and the high fees, investment bonds also:
- have a much narrower range of investment options
- have restrictions on how much you can contribute each year (max of 125% of previous year’s contribution)
- have restrictions on when you can withdraw from it (tax penalties for withdrawing before ten years).
Borrowing to invest is a common strategy because the interest is tax-deductible (the same idea as negative gearing property). Borrowing to invest in investment bonds are sometimes put forward as a doubly tax-effective investment. Unfortunately, along with the investment bond not being tax-effective for most people as explained above, the interest when borrowing to invest in investment bonds is also not tax-deductible due to the investment bond not being taxed in the individual’s own name – another downside to investment bonds vs investing in your own name.
Are they still useful?
There are a couple of specific cases to consider the use of investment bonds.
One is in estate planning – the convenience of investing for another person in a way that would be inaccessible by certain other parties. For instance, a grandparent wanting to invest for their grandchild without the child’s parent having access. This is due to being an insurance product. The money added is actually an insurance premium, and the person paid out to is the life insured. A discretionary trust would be a useful alternative, but there are high costs and complexities to set up a discretionary trust, so an insurance bond may be a simpler solution for those without substantial amounts of money. In that case, it would be a trade-off between all the issues mentioned above vs. ensuring that in the case something happens to you, the investment proceeds will go to the right person.
Another is the impact on government benefits. For instance, Family Tax Benefit (FTB) could be a factor affecting couples with young families in regards to the decision of investing using an investment bond (where you incur no personal tax liability) vs investing in a minor trust (mentioned in the next paragraph) where it is added to your taxable income and therefore may reduce FTB payments. If you’re within the thresholds to get both FTB-A and FTB-B, you may lose an equivalent of 20% of the investment’s income returns from each of those. So remember to factor that in if you’re getting means-tested government support when doing calculations to weigh up your options.
If you’re looking for an investment for your own kids and you trust your spouse to have your kids best interests in case anything happens to you, take a look at this video and the comments by ‘dworkinout’ in this post. Investment bonds vs a brokerage account with a minor trust is discussed. A minor trust account avoids the many problems of insurance bonds (high fees, lack of CGT discount, restrictions on how much you can contribute, restrictions on when you can withdraw, etc.). The big advantage of a minor trust is that the child doesn’t need to realise capital gains when it is transferred to them until they sell, which could be years or decades later. However one thing that is unclear is whether the dividends must be declared in the name of the parents or child. I’ve read comments going both ways by a variety of financial advisors, accountants, and tax-lawyers. The ATO’s information is as clear as mud.
AFI with DSSP (Dividend Substitution Share Plan) is mentioned in the video, and WHF with BSP (Bonus Share Plan) is mentioned in the reddit page. The result in these options is that all distributions are counted as capital gains, so it gets around the issue of income being taxable in the policyholder’s name. The downside is that AFI and MLT are invested entirely in the concentrated Australian market, so you may like to consider splitting in some global shares even though there will be some taxable income included. Those getting FTB support might lose quite a bit of the FTB payment so do the numbers. A way around this may be that if you have non-deductible debt, you could debt-recycle. Although not everyone has non-deductible debt.
Investment bonds are terribly tax-ineffective for anyone but those on the highest marginal rates due to losing the CGT discount, loss of ability to earn returns on future tax payable, and loss of ability to leave it invested until you are on a lower marginal tax rate such as in retirement. They also have high costs further reducing any potential benefit, restrictions on how much you can contribute, and restrictions on when you can withdraw from it.
Holding the investments in the name of a low-earning spouse, or distributing via discretionary trust, gives you the benefit of the CGT discount, as well as the tax-free thresholds during the life of the investment.
Additionally, if you have non-deductible debt such as PPOR debt, you can take advantage of debt recycling to offset income gains from a diversified investment without the issues associated with using an investment bond.
However, if you are looking for a way to ensure a specific person receives the money, or if you are getting government support, you will need to consider the pros and cons. Don’t forget to investigate the use of trusts as an alternative option.
Special thanks to Kyle Frost for mentioning these rarely-explained tax effects of investment bonds on forums and articles to help people make informed investment decisions.
Investment bonds – Millennial Independent Advice
Investment Bonds – A diabolically ineffective investment structure
Investing for Kids (The Good, the Bad and the Ugly)
Investing for kids (Part 2) – The Good, the Bad and the Ugly
Investment Bonds – GenLife – AussieFirebug (read the comments by @keith_invests, they’re accurate)
Investing for a baby and not touching till 18 – Whirlpool
The strategic fit of investment bonds – Part 1: timeframe of 10 years or more | Macquarie
The strategic fit of investment bonds – Part 2: split portfolios | Macquarie
The strategic fit of investment bonds – Part 3: timeframe of up to eight years | Macquarie
1 0.60% fee up to $50,000, 0.40% next $450,000, 0.30% next $2,000,000.