Talk to me about Investment Bonds

29.09.21 Investing By Anthony Hourigan
Talk to me about Investment Bonds

 

For several reasons, investment bonds are being increasingly utilised by a broad spectrum of the public. Some of the motives behind making use of investment bonds include:

 

 

Whether looking to give something extra to your kids, or simply to fund what’s ahead of them, then as with everything – a little planning goes a long way.

 

There are various ways to save for, or on behalf of a child. One investment vehicle that has merit for investing for children is an Education Bond, or Investment Bond. There are some differences between the two, but the features common across them relate to the special tax treatment, especially when held for ten years or more. This is one of the reasons many investors find them of great benefit, since there is the ‘reward’ for long-term investment. The reward being that after ten years, there is no tax payable on earnings. The benefit here is obvious, but let’s use an example to demonstrate.

 

Assume an investor on a marginal tax rate of 40% placed money in a managed fund in their own name, as opposed to utilising the investment/education bond, and assume all other factors remain equal such as earnings rate and no additional contributions:

 

  Year 1 Investment Ave. Earnings p.a. Year 11 Value Investment Earnings Tax Liability* Net Value
Managed Fund $ 100,000 7% $  196,715 $  96,715 $  (19,343) $  177,372
Investment Bond $ 100,000 7% $  196,715 $  96,715 $  – $  196,715

*Tax calculated by multiplying all investment earnings by 40% (investor’s marginal tax rate) after applying the 50% CGT discount as the investment has been held >12 months

 

As you can see, the difference is meaningful and significant (19% of the value of the initial investment!). The higher the investor’s tax rate, the greater the benefit of utilising the tax treatment of the investment bond. You can see the appeal when planning for events that you know are ten years or more into the future, e.g. university fees, weddings, grandkids’ school fees, kids’ first home, etc.

 

Tax Treatment

 

The table below summarises the tax treatment of earnings across the life of the investment.

 

Year of Withdrawal  

Tax Treatment

Year 1 – Year 8 100% of the earnings on the investment bond are included in your assessable earnings, with a 30% tax offset applicable
Year 9 Two thirds of the earnings are included in your assessable income, with a 30% tax offset applicable
Year 10 One third of the earnings are included in your assessable income, with a 30% tax offset applicable
After 10 Years 0% of the earnings are included in your assessable income

 

The 30% tax offset comes about due to the investment manager having paid tax on the earnings over the life of the investments, at the company rate of 30%. Worth bearing in mind, that this rate of tax can be significantly lower after factoring in franking credits the investment manager can utilise.

 

Regular Contributions

 

Some of the other features relate to the limits on how much or how little you can put into the bond. At the outset, there are no upper limits on your initial investment. There is typically a minimum investment of $1,000 in the first year. After the first year, you can contribute up to 125% of the prior year’s contribution. This can be particularly useful for savings plans, and to ‘set and forget’ the regular payments. This is when investors really start to see the benefits of compounding interest combining with regular contributions.

Using the same example where the investor starts year 1 with the $100,000 investment and experiences investment returns of 7% p.a. on average. Now we’ll assume the investor makes regular contributions each year starting with $20,000 in year two and then of 125% of the prior year’s contribution. The returns and therefore the tax benefits start to magnify. The profile of the investment over time is shown in the below chart:

 

 

The contributions increase at 25% per year, but the account balance starts to increase at an increasing rate, due to the investment returns on the larger balance each year. The bonus comes via the tax exemption, since the investor has not made any withdrawals on their investment. At year 11, total accumulated earnings on the investment are $347,016 or 24% of the total value. Had this investment been made outside of the investment bond, the individual investor would now need to declare the profits and pay tax accordingly. However, since it was made through the investment bond, there is zero tax payable on earnings, while the investor has accumulated the sum of $1.423m over the 10 years.

 

Education Bond Example

 

Jason & Jules have a son William who is approaching primary school, and they realise it’s only 7 short years until he will be in high school. They can comfortably pay William’s primary school fees and ancillary education costs, but they are worried about high school. Jase & Jules live on the south coast and they both agree they want him to go to the private boarding school in Sydney that Jason attended, and they know the fees are very high. They have calculated that William’s high school fees are going to average roughly $40,000 per year, before they allow for school trips and other add-ons. They are worried that at present, they only have $100,000 set aside and figure they can save an additional $10,000 per year up until high school, but that will not cover the 6 years at high school. William’s grandparents (retired) let Jason & Jules know that they want to assist and have set aside $50,000 for exactly this purpose.

Jason & Jules sought financial advice, and it was determined that an education bond would be of benefit to achieve their goal of sending William to their high school of choice without causing undue stress on their budget.

The combined $150,000 was used to purchase an education bond, which was able to achieve (to stick with the above examples) 7% p.a. Jason & Jules contributed their $10,000 per year towards the bond while William was at primary school, and once he reached high school, they began to have the bond reimburse them for all education expenses.

In year 11, William made the 1st XV rugby team, which happened to be the school’s centenary year. The school marked the occasion by sending the 1st XV on a European rugby tour. This was unexpected and a cost of roughly $15,000. Other than this, Jason & Jules were reasonably close with their estimates of $40,000 per year.

The alternative option they considered was to leave the $150,000 in a bank account earning 0.25% p.a. held in individual names. The marginal rate of tax between David, Rebecca and William’s grandfather is 40%. The comparison of the two scenarios between now (William is about to start Kindergarten) and when William finishes year twelve, is summarised as follows:

 

  Starting Amount Contributions Total Earnings Education Costs Tax Liability Residual Balance
Bank Account $150,000 $60,000 $5,312 $274,000 $ (1,062.40) $ (59,750.40)
Education Bond $150,000 $60,000 $206,056 $274,000 $ – $142,056.00

 

Over the course of William’s schooling, by utilising the education bond, Jason & Jules are $201,806 better off. Furthermore, had they not utilised the education bond, they would have been out of pocket – and had to come up with a way to finance – nearly $60,000 for William’s final year of school.

They now have the fortunate decision of what to do with the remaining $142,056. They could withdraw the full amount from the bond with no tax payable. Or, they could decide to use it to help fund William’s university, or other tertiary education. Just as the bond had been used to pay all William’s school fees, uniforms, travel, laptops, etc. it can be used in the same way for his higher education.

Of course, as with any investment, there are risks. There is the performance risk of the chosen fund manager, as past performance is no indication of future performance. It is possible that the performance of the fund manager deteriorates significantly, and the value of the education bond actually goes down. For this reason, choice of investment manager is critical.

 

An Alternative to Superannuation

 

With the introduction of the contributions cap in 2017, many high-net-worth investors are being forced to look outside of superannuation for tax-friendly vehicles for investment. Not surprisingly, their attention is turning to investment bonds as a way of growing wealth and helping children and grandchildren in a tax-efficient manner. Unlike superannuation, there is no limit as to how much you can contribute to an investment bond, and there are no restrictions on when you can access the capital. Of course, there is the added benefit of zero tax payable on earnings after ten years.

 

Conclusion

 

As with any investment vehicle, there are pros and cons of investment bonds. However, investment/education bonds have a flexibility such that they are very likely to suit a large portion of the public at various stages of their life. The tax-efficiency makes them very compelling, as does the ‘set & forget’ nature of regular contributions for those looking to save.

If you would like more information, or you feel this is something you would like to explore as it relates to your objectives, please feel free to get in contact with us at cloudbreak@cloudbreakwealth.com.au

 

General Advice Warning

 

Any advice given herein is general in nature and has not taken into consideration your personal financial objectives, situation or specific needs. You should consider the appropriateness of the advice as it relates to you before acting upon it. Where a specific product has been mentioned, you should always consult the PDS before making any investment decision relating to it.

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