Your beginner's guide to investment bonds
Think investment bonds are in the same family as corporate or government bonds? Think again.
Unlike traditional government or corporate bonds that promise a fixed return, investment bonds are something entirely different.
This guide will break down what investment bonds are, who they suit, and how you can invest in them.
What are investment bonds?
An investment bond is a financial product that combines features of both life insurance and investments. Think of it as a container for your investments, akin to a superannuation fund or family trust. Within this structure, you can choose from various investment options, such as equities, property, and fixed interest.
The "bond" part of the name refers to the relationship between the policy owner and the life insured, governed by the Life Act.
"Just like superannuation, investment bonds are tax-paid investments, meaning all the taxing is done and paid within the investment bond itself and doesn't form part of your personal tax return," says Felipe Araujo, Generation Life's general manager of sales, marketing, and operations.
"The provider of the investment bond handles the taxation of earnings at a flat rate of 30%."
Investment bonds allow withdrawals without age-based limitations, and investors can withdraw some or all of their investments at any time.
"If you hold the investment bond for at least 10 years, you can withdraw the earnings tax-free, making it a tax-efficient investment vehicle," says James O'Reilly, founder and financial adviser of Northeast Wealth.
However, O'Reilly notes that an important aspect to understand about investment bonds is the 125% rule.
This rule states that in any given year, you cannot contribute more than 125% of the amount you contributed in the previous year without resetting the 10-year period required to make your earnings tax-free.
"If you exceed this limit, the 10-year clock starts again, which can significantly diminish the value of your investment bond," O'Reilly explains.
Who are investment bonds suitable for?
- High-income earners: For individuals with high incomes, the tax payable on an investment bond is lower compared to what they would have paid if the investment was in their own name. According to O'Reilly, high-income earners might face tax rates as high as 47%. In contrast, am investment bond taxed at 30% would result in much better tax outcomes for them.
- Anyone focused on estate planning: Unlike assets distributed through a will, which can be contested and a long take time to settle, the beneficiary nominations in an investment bond are legally binding and can be settled quickly-often within seven working days.
- Young families: Investment bonds are also suitable for young families who are saving for home ownership or education.
What are the cons?
- Complexity: Understanding the structure and benefits of investment bonds can be challenging. There are a number of different tax considerations and contribution rules, which can be complex.
- Higher fees: Investment bonds may have higher fees compared to other investment options. However, O'Reilly notes that exciting new products are driving fees down. "We could be looking at the golden years for investment bonds," he says.
- Illiquidity: Accessing funds before the 10-year period can result in additional taxes. Early withdrawals are taxed on a sliding scale, so a long-term investment horizon is best.
- Better alternatives: ProSolution Private Clients owner and director Stuart Wemyss says he rarely recommends investment bonds due to the availability of more effective and flexible alternatives, often at lower costs. "A holistic, long-term financial plan often reveals better options," he says.
How do you buy investment bonds?
Purchasing an investment bond is straightforward. They can be bought through a financial adviser or directly from companies such as Generation Life or Australian Unity, with a minimum investment of $1000.
"Anyone can start them with a fairly low contribution amount, even as low as a few thousand dollars," O'Reilly says.
"However, again, it's important to be aware of the 125% rule to avoid restarting the 10-year period."
To sum things up
Investment bonds are a powerful tool for tax-efficient investing and estate planning, offering stability under the Life Act.
However, they can be complex, and it's essential to understand their potential drawbacks.
"Although they're a fantastic product, there are a couple of little traps that can diminish the value of your investment bond significantly," O'Reilly says.
"Financial advice can help navigate the complexities of tax implications and contribution strategies, ensuring that the investment bond aligns with your long-term financial goals."
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