What are the tax benefits of insurance bonds? Really, what are they?

(This article was written a year or 2 ago and I've just recently updated it)

What's so good about insurance bonds?

I mean really? What is so good about them? Can someone please help me?

They often get wheeled out for high income earners that are too far away from preservation age to invest in superannuation or a good child savings tool because the income doesn't get added onto anyone's marginal tax rate. Noel Whittaker seems to love them and gives them a shout out regularly in his 'ask noel' column in the Brisbane Times. Here is the latest one (update: this article is quite old now and he's probably mentioned them since)

Anyway, what is it? An insurance bond is an investment product, like a normal managed fund but is taxed internally at the company tax rate - 30% instead of your marginal tax rate. This is good right? So many of us are on a tax rate higher than 30% - for example the 34.5% tax rate starts at an annual income of $37,000 - and most working people earn above that.

Well, they're not as good as they might appear on face value. First of all, you need to be invested for 10 years otherwise when you redeem, the profits are added back to your personal income (with a tax offset for the tax already paid inside the bond), so to get the benefits, you need to invest for a minimum of 10 years and on top of that, you can only invest up to 125% of the amount you contributed the year before. If you exceed that, the 10 years restarts.

So, if that is all ok, what's the problem then? Lower tax right? Yes. So if you are looking at an investment that is purely income (no capital growth) such as a cash investment or a fixed interest investment, then the income each year is going to taxed at a lower rate than what you would pay if invested in your name. But, if you take into account the additional administration fee of an insurance bond over the same investment in a normal managed fund, then for someone on the 34.5% marginal tax rate, then you're better off just with the additional tax of investing in your own name, someone on the 39% tax rate, it's line ball and on the 47% tax rate you are better off with the insurance bond (this varies a little bit depending on the actual income), but keep in mind that's for an income only investment in an insurance bond for 10 years. Is that what people on a marginal tax rate of 39%+ are doing? Investing in cash or fixed interest for 10+ years? I don't think so.

On to the growth - this is where it gets messy. I'd guess that a growth based investment is where a lot of the attraction of insurance bonds lie - after all, as I've mentioned, it's a 10 year play so people are probably going to take some investment risk.

When you own an investment such as property or shares, we know that you don't pay capital gains tax unless it is sold (or some other CGT event). The same is the case for assets held within an insurance bond - but that doesn't mean that if you hold an insurance bond for 10 years, that you can redeem and get away without there being any capital gains tax inside the bond. The insurance bond always keeps a provision for unrealised CGT when providing crediting rates to investors because they can't have people leaving a bond with an unrealised CGT liability inside the bond for the next guy to pick up. So, even though money might remain invested, the return you get is essentially after 30% capital gains tax on any growth.  This point is really important as I think this is where a lot of the misconception lies. You don't invest in an insurance bond, have the underlying assets rise in value over 10 years, then you get out without paying CGT. If the underlying assets have risen in value, but a CGT event hasn't occurred, the return you get is after a provision is made for paying the 30% tax on growth.

When you have an investment in your name, you pay capital gains tax at your marginal tax rate but providing it's been held for more than 12 months, you get a 50% CGT discount, so only half of the gain, so if you are on the top marginal tax rate - that's essentially a tax rate of 23.5% - better than an insurance bond.

So if  (for someone on the top marginal tax rate) capital gains are better in your own name, and income is better in a bond (marginally after taking into account the additional administration fee), is there really a benefit to holding an insurance bond for tax purposes?

Let's have a look at some performance figures - I've taken screen shots as websites update and I want there to be a comparison as at the same point in time (30 June 2018).

These performance figures show the after tax return for someone on the top marginal tax rate after taking into account capital gains tax if the investment is sold (top highlighted boxes) versus the return for the same investment in an insurance bond (bottom highlighted boxes).

Australia Shares Index 

International Shares Index (Hedged)

So, as you can see from the screenshots above is that someone on the top marginal tax rate would be marginally worse (0.07%) off after 10 years in the Australian shares index fund rather than in the insurance bond, and a bit better off (0.53%) in the international index fund (hedged) than in the insurance bond. Lets compromise and say a diversified fund (a mix of both) results in the insurance bond being no better or worse than someone who is on the top marginal tax rate throughout the entire time of owning the direct fund, and selling whilst also on the top marginal tax rate.

Lets hear some of the arguments for insurance bonds and my opinion on them.

• They're tax effective for high income earners - See above. Line ball at best for someone on the top marginal tax rate throughout ownership and selling the investment (even someone earning a high income and being in the top marginal tax rate could plan their exit from their investments after retiring and on a lower tax rate)
• You can switch which investment bond midway through without any taxation penalty - Yep - see above again - if the after tax return (after incurring CGT) is just as good for an normal investment as an insurance bond, you could also sell and buy a different investment if you owned it directly. You could also use the money for any other purpose too with the same net return as the equivalent insurance bond.
• If someone has a lower income year during the 10 year period, you can sell, pay tax on the earnings but get an 30% offset so you can get out during the 10 year period in that case with little or no additional tax. Yep - and if they owned the investment directly, they could sell in that same lower income year and their CGT on the investment would be much lower meaning their net return would actually be higher than the bond returns.
• The returns provided by bond provider are net of fees and they have a reduce admin fee for amounts invested above $500,000 (note: currently there is an offer for a discount for amounts above $50,000 for something like the next 3 years). So for a big investment, the bond's net returns would actually be a bit higher. I would argue that if someone is investing over $500,000 and is on the top marginal tax rate now and for the next 10 years, they're probably better off with their own investment entities - ie. within a family trust with a company as a beneficiary.
• They're great for estate planning as they can pass to the beneficiary without tax. So can any other investment (other than superannuation). You can't confuse superannuation death benefit taxes and a bond being tax free to beneficiaries as bonds are not part of your superannuation anyway.
• You can nominate a beneficiary and the money can stay out of an estate so someone can't make a claim on your estate - Yep. Good strategy. Uncommon, but worthwhile in these small cases. This is not a tax planning strategy though.
• By having the money invested in a bond, there is no earnings applied to anyone's income so won't affect any benefit (family tax benefit, super concessions etc) that is based on taxable income - This is also one of the few benefits (I actually don't hear this one but is one of the few actual good benefits). However, practically, unlikely to ever come into play. As we've said above - the returns are line ball for someone on the top marginal tax rate - and someone on top marginal tax rate isn't getting FTB or other government benefits. Someone on lower tax rates would get a higher net return if they invested directly, so the benefit of the increased centrelink/government benefit needs to overcome the lower net return in the bond. Realistically, there is unlikely to be instances where this happens. I can't see someone with say $100k investment, getting FTB, and investing in the bond will improve the FTB enough to justify the lower returns. But, it could happen, it would be rare though.
• They are good for investing for children because of the high tax rates for minors for unearned (investment) income - I haven't met many minors who have accumulated sufficient funds on their own for this to be an issue. This is about parents/grandparents giving them money. So, as I've said above, if there is better taxation outcomes by investing in their own name, at their marginal tax rate, then they can do this and just sell later and give the child, grandchild the money at that time. Alternatively, you can just invest in the childs name (yes they'll pay top marginal tax rate on the income) then if they sell after they reach 18, then they'll have adult tax rates on the CGT and more than likely pay very little CGT if they sell while still a student or are on a low marginal tax rate and wind up in a better position than if they achieved the poor after tax returns of the insurance bond. Just don't buy an actively managed fund that will keep turning over the portfolio and generating realised capital gains throughout the period of ownership.

So, to sum up insurance bonds a bit:

1. They are more expensive for the exact same funds, so straight off the bat you are actually going to get worse gross returns before you even factor in tax.
2. As a bond pays CGT at 30% with no discount, the investment needs to pay a fairly reasonable amount of income (relative to growth) for it to even be close. 
3. You have to keep them for 10 years before you can redeem them and enjoy those 'supposed' tax benefits.
4. You can only invest 125% of the value of investments you made the previous year, so if you invested $10,000 last year, you can only invest $12,500 this year. If you only end up doing $5,000 this year, then you can only do $6,250 next year. So you can't be flexible with your investing. If you miss a year - that's it. No more unless you will restart your 10 year.

So with these negatives and with the outcomes being, lets call it 'line ball' even when calculating on the top marginal tax rate, why do it? In reality, it is very uncommon for both members of a couple to be on the top marginal tax rate throughout the whole time and then sell prior to retirement (granted, not everyone is in a long term relationship).

There would be some very obscure circumstances where it may be warranted for a complex asset protection or estate planning scenario, but I honestly believe it is an oversold product to make people think they are getting some great fancy outcomes but in reality, it isn't.

NOTE ON RETURNS: Vanguard providing after tax returns is based on complicated calculations and assumptions and actual net returns may vary very slightly. Also, the comparison with the Genlife insurance bond returns is using their index portfolios which is now managed by Blackrock, not by Vanguard, however they were previously managed by Vanguard (so part of those longer term returns are from when Vanguard were managing it) and they're both index funds, so they both track the index almost identically.