An investment bond is essentially a flexible savings product that can grow investors’ money over time, coupled with certain tax advantages. 

Under most conditions, the income earned in the investment bond is taxed within the fund at the ordinary business tax rate (currently 30 per cent). Therefore an investment bond can offer investors an attractive alternative to superannuation for saving for retirement. 

Indeed, investment bonds are very complementary to SMSFs, and it can make a lot of sense for people to have both structures running in tandem.

One key benefit for those approaching retirement is that there is no limit on how much can be put into an investment bond at establishment. So investors who are selling a major asset as they get close to retirement – such as a business or the family home – can put as much of the money into an investment bond as they want, with no concerns of breaching caps. This contrasts with superannuation, where there are very stringent caps on how much can be contributed each year.

But there are other advantages as well.

Investment bonds key features

First let’s look at the key features of an investment bond. The first is the 10-year tax rule, which is a tax incentive specific to investment bonds due to their heritage as a product offered by friendly societies. This allows income earned in the bond to be taxed at 30 per cent and paid for by the issuer – that is, paid in the bond.

This means investors do not need to declare any income accrued, or capital gains tax earned, in their personal tax return. If they keep the investment bond running and don’t make a withdrawal until after 10 years, then they also don’t need to pay tax on income from their withdrawal.

But investors do need to meet the 125 per cent contribution rule if they want to receive investment-earnings tax free after 10 years. This means that while the contribution amount in the first year of the bond is uncapped, subsequent contributions cannot exceed 125 per cent of the previous year’s contribution.

If the 125 per cent contribution is exceeded, or the investor doesn’t make a contribution one year, the 10-year rule will reset. That means they will have to wait another 10 years before they are able to withdraw the funds with no tax to be paid.

Another benefit is that, unlike superannuation funds, investment bonds allow people the flexibility to access the funds whenever they wish, subject to certain investment requirements being met.

And finally, the investment bond provides the option to invest in a number of different underlying investments across different asset classes such as cash, fixed interest, shares, property, and infrastructure, with their varying risk levels. Investors may even be able to invest in socially responsible or environmental, social and governance options, allowing them to build their savings at the same time as investing for the greater good.

General savings benefits 

Therefore the key to an investment bond being a successful tax effective investment is to set up a savings plan to make sure an annual contribution is made that complies with the 125 per cent rule. 

If saving as much as possible is important, then the first year’s contribution will set the bar for subsequent contributions, which cannot exceed 125 per cent of that amount.

In addition to superannuation, investment bonds are useful investments to build up funds for specific goals over a 10-year period, such as saving for a child’s education, saving for a home loan deposit or other large purchase such as a car, boat or caravan, or perhaps saving for a big overseas holiday upon retirement.

Estate planning benefits

In addition to the 10-year tax rule, there is another advantageous tax treatment of investment bonds which make them suited to estate planning. 

On the death of the life insured (i.e. the person who has taken out the investment bond) the investment proceeds of the bond will become tax free for the nominated beneficiary.

It is also a much simpler process to set up an investment bond than it is to set up some legal structures such as testamentary trusts. Investment bonds, if taken out for the correct beneficiary, also cannot be overruled or changed through a challenge to a Will. This is particularly useful in situations where there are complex, multi-generational family structures.

Investors do not need to worry about such things as binding death nominations, as in the case of superannuation, and a holder of an investment bond can nominate a beneficiary anytime to receive the tax-free proceeds of the investment bond in the event of their death.

Wealth transfer benefits 

Investment bonds are also a helpful tool for transferring wealth to children who are minors or investing on behalf of children.

Income earned on investments held in the name of a minor are usually taxed at the highest marginal tax rate (to prevent income-splitting and tax avoidance). But because investment bonds have a capped tax rate, an investor will only pay a maximum of 30 per cent on the earnings while they are invested in the bond.

If the 10-year time period has been reached – say you begin an investment bond for your child when they are five years old to access once they reach 18 - there is also no capital gains tax paid on the transfer of the policy to the beneficiary – your child. You can nominate different vesting ages throughout the life of the investment bond, as long as the 10-year period has been reached, and you comply with the 125% rule. 

For example, you may decide you would prefer if your child waited until they were more responsible at 21 to access the funds. Or perhaps you want them to use the funds to buy their first car so you could lower the vesting age to 16.

Outside the box

Investment bonds are a practical and tax-effective alternative for wealth building over a period of 10-years or more. And while often overlooked, they are worth considering for anyone looking to save for a particular goal, transfer wealth to a child, or seek tax-effective estate planning options.

By Emma Sakellaris, chief executive officer, Foresters Financial