Investment bonds. Summary. Who may benefit from an investment bond? TB 33

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1 TB 33 Investment bonds Issued on 1 July Summary There are a wide range of investments to choose from in today s market. One option is an investment bond which is a life insurance policy purchased with a single payment or, with some planning, through a series of payments. Who may benefit from an investment bond? There are a number of clients who may be interested in using investment bonds. Clients who can benefit from investment bonds include: Clients who are saving for a specific purpose, eg child s education Clients who pay higher marginal rates of tax Clients who wish to provide the proceeds of an investment to a beneficiary with certainty Clients who could potentially face bankruptcy in the future Clients who want to minimise aged care fees by investing via a private trust. Investment bonds are tax paid investments. Life insurance companies pay tax of 30% on the earnings prior to the declaration of returns or units prices. The value of the policy will depend on the amount invested and investment earnings. Growth in the value of the bond is tax paid after it has been held for 10 years. Withdrawals within 10 years will result in the full amount or a proportion of the growth being included as assessable income in the client s tax return. However a 30% tax offset equal to the tax paid by the life company will reduce the tax payable (if any). Clients who Seek to save funds for a specific purpose eg children s education Wish to manage their tax position Wish to provide for beneficiaries with certainty Are at risk of bankruptcy Reasons why an investment bonds may be suitable The investment is tax paid after 10 years (encourages long term investment) Additional contributions can be made each year without restarting the 10 year period Does not directly affect the tax position of the owner unless withdrawn within 10 years The earnings of an investment bond are taxed in the hands of the life insurance company and not at the person s marginal tax rate. Investment bonds allow benefits to be directed to a person without forming part of the deceased s estate. Investment bonds are protected from the trustee in bankruptcy where the life insured is the bankrupt individual or their spouse. However transfers to an investment bond intended to defeat creditors may be available to the trustee in bankruptcy.

2 Taxation Earnings Earnings, including realised capital gains, on an investment bond are taxed at the life company rate of 30%. The fund also receives the benefit of franking credits and other tax benefits from the underlying income derived. Withdrawal made Within 8 years* Between 8-9 years* Between 9-10 years* Amount of growth included in tax return Full amount Two-thirds One-third No amount is included in the client s assessable income unless a withdrawal is made before the end of the 10 year anniversary. The anniversary date is the date the investment bond was purchased. The full amount of the capital gain is taxed at 30%. While individual taxpayers receive a 50% discount on capital gains realised on assets held for at least 12 months, this concession does not apply to life companies. If a withdrawal (or redemption) is made before the investment bond has been held for 10 years, a portion of the growth is included in the person s assessable income. A tax offset is available representing the tax already paid while the investment was held. Withdrawals or redemptions Withdrawals after 10 years The earnings (or growth) on an investment bond is tax paid after it has been held for 10 years. Funds can be withdrawn and the growth component is not included in the client s tax return where an investment bond has: Been held for a continuous period of 10 years immediately prior to withdrawal; and During this period the 125% rule has not been breached. (See section 125% rule additional contributions ). Withdrawal made After 10 years Amount of growth included in tax return Nil Withdrawals within 10 years Funds can be accessed at anytime but how long the bond has been held, determines the amount included in the person s tax return. Withdrawals made within 10 years of commencement or within 10 years of the last breach of the 125% rule are taxed in accordance with the following table: * Where there has been a breach of the 125% rule this effectively becomes year 1. Where an amount adds to assessable income, consider the impact this may have on other benefits, eg Family Tax Benefit or the Commonwealth Seniors Health Card. Where there is no growth on the withdrawal, there is no impact on the tax return (ie a tax loss is not available). Calculating the growth amount The growth amount is calculated in accordance with the following formula: A / B x [(B + C) - (D + E)] Where: A = amount of current withdrawal B = surrender value immediately prior to withdrawal (not of the investment option in which a withdrawal is being made but of the entire policy) C = total of any withdrawal amounts already paid out D = gross premiums paid to date (ie without deduction of charges such as commissions and management fees). E = previous amounts included in assessable income James places $1,000 into an investment bond each year. Immediately before the end of the 8th year the policy is worth $15,000. Details for the investment bond are: Investment bond Investments (premiums) Amount $8,000 Previous withdrawals $0 Surrender value $15,000 2

3 $5,000 is withdrawn from the investment bond. The growth amount included in the tax return is: A = $5,000 B = $15,000 C = $0 D = $8,000 E = $0 = $5,000 / $15,000 x [($15,000 + $0) ($8,000 + $0)] = $2,333 30% tax offset Any amount received from an investment bond that is included in a person s tax return is entitled to a 30% tax offset. This is equal to the life company tax rate which applies to earnings within the bond. The tax offset is non-refundable which means that there is no tax refund if the tax offset exceeds the tax payable. Using the example above, as $2,333 is included in the tax return, the tax offset is: $2,333 x 30% = $700 Tax free withdrawals in special circumstances Death Any amount received due to the death of the life insured, is tax free. This is irrespective of the 10 year rule. Pre 28 August 1982 Investment bonds If the bond started prior to 28 August 1982, any amounts withdrawn are not included in assessable income. Accident, illness or disability If the bond is surrendered due to an accident, illness or other disability suffered by the life insured, no amount is included in assessable income. Severe financial hardship No amount is included in assessable income where the bond is surrendered because of serious financial difficulties of the owner. Considerations Higher income tax payers A taxpayer on a marginal tax rate above 30% may achieve an overall higher investment value by using an investment bond and maintaining it for at least 10 years. This may include children under age 18 due to the removal from 1 July 2011 of the low income tax offset (LITO) for non-working (unearned) income that is taxed at penalty rates. The earnings on an investment bond are taxed at 30% within the bond. The earnings are not added to the person s assessable income when it is earned on the bond. This means that assessable income and taxation is managed. Max, a widow, is 81 years of age. He is currently generating $100,000 from his investments, including a lifetime annuity purchased in 1985 which is indexed to inflation. The current level of income is above Max s requirements. One of his objectives is tax planning. Given Max s position the following strategies are not available: superannuation no personal contributions can be made income splitting as he does not have a spouse. His financial adviser recommends investing a portion of his savings in an investment bond to assist in managing his tax position. By using an investment bond: he reduces his assessable income his marginal tax rate is now 32.5% earnings on funds held in the investment bond are taxed at 30%. If taxation is a key issue for a client other investment options, such as superannuation, should be considered however access to capital may be limited due to preservation. Lower income taxpayers Taxpayers on lower marginal tax rates may benefit from cashing in all or part of the bond earlier. This is because, when the bond is cashed in, there is a 30% tax offset available. If the person s marginal tax rate is less than 30% the extra tax offset can be used to offset tax payable on other income. Therefore if the bond is 3

4 cashed within 10 years, it may be worthwhile holding funds in the name of a person who pays less than the 30% marginal rate of tax (eg nonworking spouse). Investors close to retirement can use investment bonds as an effective means of deferring assessable income to a time after retirement, when their marginal tax rate may have fallen. Clients with a marginal tax rate of less than 30% can maximise their after tax return by cashing in bonds within 8 years. Switching investment options The underlying investment option can be switched and does not restart the 10 year period. This is an investment change within the investment structure. No tax implications are included in the client s tax return. Most providers of investment bonds give investors a choice of underlying investments, such as Australian shares, international shares, balanced etc. 125% rule - additional investments Most bond providers allow additional amounts to be invested each year. Provided such amounts do not exceed 1.25 times the previous year's deposits (the 125% rule), the additional contribution will have the same start date as the original investment for calculating the 10 year term. However if funds are not added in a year and another deposit is made at a later stage it will recommence the 10 year term. The initial contribution used to commence the bond is included in the first year s contributions. Some providers may limit additional amounts to ensure the 125% rule is met, however, other providers may not cap additional amounts. Intentional breach of 10 year rule You can reset the 10 year period by intentionally breaching the 125% rule, even if 10 years have already elapsed in the bond. This may be beneficial for clients with a marginal tax rate lower than 30%. Steve has held an investment bond for 12 years. Over that period of time, the bond has grown from $20,000 to $40,000. Steve has retired and now only has $20,000 of income for the year. As such, Steve intentionally breaches the 125% rule then withdraws the funds in the bond, causing the $20,000 to be added to his taxable income with a 30% offset applied. As Steve is now only just in the 32.5% marginal tax bracket (and can also benefit from the low income tax offset), the growth in the bond is taxed less than it would have been had it remained in the bond and was taxed at 30%. What happens on death? An investment bond is a life policy. The death of the life insured will trigger the payment of the investment bond either to the nominated beneficiary or the policy owner if no beneficiary is nominated. If the life insured is the policy owner and there is no beneficiary, then it is paid to their estate. If there are multiple lives insured, the account balance is payable on the death of the last surviving life insured. When purchasing an investment bond it is important to consider the policy owner, life insured and beneficiary. Policy owner The policy owner is the person who owns the policy. The policy is an asset of the policy owner and they are able to make changes to it at anytime eg change beneficiaries or investment options. On the death of the policy owner (who is not the life insured) this asset is transferred to a new owner in accordance with the policy owner s Will. However if the owner of a child advancement policy dies, during the child s lifetime and before the child reaches the vesting age, the executor of the deceased s estate holds the policy in trust for the child until they reach the vesting age. The executor may assign, withdraw or vary the policy and/or apply the proceeds for the benefit of the child. Beneficiaries The beneficiary is the person who is nominated to receive the investment bond proceeds on the death of the life insured. There are no restrictions 4

5 on who can be named as a beneficiary of an insurance policy (unlike superannuation which restricts who can be a beneficiary). This anniversary date is based on the date the original owner purchased the investment bond. Agnes is 78 years of age. She has three adult children who are all financially secure so she does not wish to give her capital away at this time. The income she derives from investments is above her current requirements. One of Agnes goals is estate planning. Agnes adviser recommends an investment bond with her as the policy owner and life insured. The bond achieves her estate planning goals by: Phil purchased an investment bond on 1 July On 1 July 2009 he gifts the bond to his son Peter. There are no tax consequences on the transfer of the investment bond to the new owner. On 1 July 2013 Peter fully withdraws the funds in the investment bond. As the bond has been held for over 10 years, no amount is assessed in Peter s name. Paying proceeds upon her death Allowing her to nominate the three children as beneficiaries (bypassing her estate) Simplifying the taxation of the inheritance as there is no tax on receipt of the proceeds by the beneficiaries and no CGT implications. Original purchase date 1/7/2000 Transfer of ownership 1/7/2009 Withdraw on 1/7/2013 Transfer of ownership of investment bond The transfer of ownership (or assignment) of an investment bond may have tax implications. Ownership may pass due to the death of the policy owner (who is not the life insured) or it is gifted to another by the policy owner (eg child advancement policy). Growth determined from original purchase date Bankruptcy protection The bankruptcy legislation provides protection for an investment bond where the life insured is the bankrupt or their spouse, unless the amount transferred into the investment bond was intended to defeat creditors. For further information you should seek legal advice. Ownership transferred for no consideration An investment bond may change ownership for no consideration if it is: inherited from a deceased estate assigned to the new owner by gift transferred to a surviving joint tenant on the death of a joint tenant. New owner The policy owner may gift the investment bond to another person, who becomes the new owner. There are no tax implications on the transfer of ownership to the new owner. The new owner now controls the investment and can make withdrawals. The tax implications of withdrawals are the same as those outlined in the section Withdrawals or redemptions. The new owner may need to include an amount in their assessable income and is eligible for the tax offset. Social security treatment Investment bonds are treated as financial assets for social security and DVA purposes. Under the assets test the account balance is an assessable asset. As investment bonds are unitised it is the unit price of the bond multiplied by the number of units owned that is the value used for asset test purposes. For income test purposes, the account balance is deemed. Using in an investment bond via a private trust can be an effective strategy to reduce aged care fees. For more information refer to Technical Bulletin 78 Aged care and fee reduction strategies. 5

6 Child advancement policies A child advancement policy is an investment bond arrangement which (according to the Life Insurance Act) meets the following criteria: policy is issued before a child has reached 16 years life insured is a child original owner is a person other than child policy provides for the payment of the proceeds to the child when they reach a specified vesting age (from age 10 to 25) until the child reaches vesting age, the policy is the absolute property of the original policy owner (or person(s) assigned ownership of the policy) when child reaches vesting age, the policy is the absolute property of the child. The 10 year period does not restart when the ownership of the bond transfers to the child. This Technical Bulletin has been produced by OnePath Technical Services and is intended for the use of financial advisers only. It is current as at the date of publication but may be subject to change. This publication has been prepared without taking into account a potential investor's objectives, financial situation or needs. Before making a recommendation based on this publication, consider its appropriateness based on the client s objectives, financial situation and needs. OnePath Technical Services is not a registered tax agent under the Tax Agent Services Act Your client should refer to a registered tax agent before relying on information in this publication that may impact their tax obligations, liabilities or entitlements. 6