The strategic fit of investment bonds - Part 3: timeframe of up to eight years

Strategies

David Barrett
Tuesday 31 October 2017

The reduced capacity for super contributions from 1 July 2017 will inevitably cause financial services professionals to consider alternative strategies. In this series of articles the relative merits of where and how investment bonds can fit into the list of investment strategy options of financial services professionals are examined.

Part I introduced investment bonds and their relative attractiveness if held for 10 years or more. Part II examined using investment bonds when splitting a portfolio into defensive and growth assets. In this article, Part III, we examine the opportunity for holding investment bonds for up to eight years.


Investment bonds versus personal investment in the first eight years

If an investment bond is realised 10 years of more after inception, the only tax paid is the internal tax paid by the life office or friendly society on returns, taxable at the corporate tax rate. However, there are additional tax implications if an investment bond is realised prior to 10 years.

Realisation in the first eight years results in the after tax returns of the investment bond being treated as assessable income of the individual, with a tax offset equal to 30 per cent of the assessable amount generally applying.

Example:

Consider $100 of investment returns generated within an investment bond. These returns are subject to tax at the corporate tax rate of 30 per cent, so $70 is paid to the investor upon realisation, plus the original capital investment.

If realisation occurs within eight years of commencement, an extra $70 will be assessed in the investor’s name in the relevant income year. If the investor’s marginal tax rate is 34.5 per cent (including Medicare levy), $24.15 of tax would be payable.

The investor will be entitled to a non-refundable tax offset of 30 per cent of the $70, or $21.

The investor’s net tax position on the $70 after tax return, would be $24.15 less $21, or $3.15. The net after tax return is $70 less $3.15, or $66.85.


Assessable income / cash flow $70
Marginal tax rate 34.5%
Gross income tax ($24.15)
Non-refundable tax offset $21
Net tax payable ($3.15)
Net benefit after tax $66.85

The effective tax rate paid on the investment returns is 33.15% (100 less 66.85) This compares unfavourably to the position if the investment bond was held for 10 years or more, as the $70 would be tax free in the investor’s hand.

Compare this also to the position of $100 of after tax investment returns generated by the same investor in personal name. Assuming the return assumptions below, approximately 51 per cent of the return is capital gains, with capital gains tax (CGT) discounts potentially applying.

If the same investment was held in personal name rather than via an investment bond, broadly the investor would realise $74.26 after tax.


Extending this analysis more broadly indicates that if the investor’s marginal tax rate exceeds 30 per cent, then realisation of an investment bond within the first 10 years is less attractive than realisation after 10 years.

However if a lower marginal tax rate applies, then realisation within the first 10 years may be preferred, as the 30 per cent tax offset may potentially exceed the tax payable on the income related to the realisation of the investment bond.

This outcome depends on the investor being able to use the non-refundable tax offset in the current income year. Any amount of the tax offset not used to offset tax payable in the current income year is forfeited.


Example:

Again consider $100 of investment returns generated within an investment bond. Tax is paid at the corporate tax rate of 30 per cent, so $70 is paid to the investor upon realisation within eight years, plus the original capital investment.

Assuming the investor’s other taxable income is $21,000, the following tax position would apply when the investment bond is realised within eight years:

Assessable income / cash flow $70
Marginal tax rate ($21,000) 19%
Gross income tax ($13.30)
Non-refundable tax offset $21
Excess tax offset $7.70
Other tax payable ($21,000) ($532)
Net benefit after tax $77.70

In this case, because the investor has tax payable on other income, they are able to use the excess tax offset ($7.70) to offset the other tax payable. Therefore the effective tax rate on the investment return is 22.3 per cent (100 less 77.70).

On the other hand, if their taxable income was $15,000, the following would apply:

Assessable income / cash flow $70
Marginal tax rate ($15,000) Nil
Gross income tax Nil
Non-refundable tax offset $21
Excess tax offset $21
Other tax payable ($15,000) Nil
Net benefit after tax $70

The effective tax rate on the investment return is 30 per cent (100 less 70).


This example demonstrates that an effective tax rate of less than 30 per cent can be achieved if an investment bond is realised within the first 10 years, the marginal tax rate of the investor is less than 30 per cent and the non-refundable tax offset can be used to offset tax payable on other income.

Chart 1 below shows the effective tax rate paid on an extra $1 of gross (after fees) returns from a balanced portfolio invested via an investment bond realised within eight years of commencement, based on the level of taxable income shown on the x-axis. The chart demonstrates when an effective tax rate of less than 30 per cent occurs at various levels of taxable income up to $100,000.

As expected, where taxable income exceeds $37,000 and the marginal tax rate rises to 34.5 per cent (including Medicare levy), the effective tax rate exceeds 30 per cent, and realisation prior to year nine is not attractive. Where taxable income is less than $20,542, no tax is payable, so the investment bond tax offset is wasted, resulting in the effective tax rate being 30 per cent.

Chart 1 shows that the effective tax rate in the income range from $27,069 to $37,000 is 23.7 per cent. Realising an investment bond that results in assessable income that falls into this range appears to be an opportunity.

The practicalities of achieving this result could be challenging. Controlling a client’s taxable income to this level of preciseness may be unrealistic in some circumstances. Furthermore, note that in Part I of this article series we determined that returns from the stated balanced portfolio held as a personal investment would be taxed at an effective rate of 14.9 per cent where the marginal tax rate of 21 per cent applies (that is, when taxable income is in the range $18,200 - $37,000). The effective tax rate of 23.7 per cent for the pre-year nine investment bond strategy does not compare well if the client’s taxable income is less than $37,000 throughout the investment period.

However, a key advantage of the investment bond strategy is control of the timing of realisation, and the assessment of the income. If an investor was subject to high marginal tax rates at the inception of the investment bond, and for many subsequent years, timing the realisation of the investment bond to coincide with a decrease in taxable income to the level described above could be effective. This might occur, for example, after retirement when employment income ceases.


Conclusion

An opportunity exists to realise an investment bond at an appropriate time (e.g. when the investor’s taxable income is approximately $27,000) within the first eight years to reduce the effective tax rate from 30 per cent.

However, that outcome requires precise control and timing of the realisation and the client’s taxable income, which may be impractical for many clients.


Further reading

Read more about the strategic fit of investment bonds in our 3 part series

Part 1: timeframe of 10 years or more

Part 2: split portfolios

Part 3: timeframe of up to 8 years



Projection Rate Assumptions

The assumed after-fees pre-tax projection rate of 6.7 per cent per annum used in this article is based on the asset class weightings, long term income and capital growth projection rates and other assumptions in the table below.

These rates aren’t guaranteed, are provided as an illustration only, and may vary from actual results. The projection rates aren’t intended to be and shouldn’t be relied on when making a decision about a particular financial product.

Values in today’s dollars are shown after discounting future values by the assumed consumer price index (CPI) projection rate of 2.5 per cent per annum.


Asset AllocationCapital GrowthIncomeFranking PercentageTax free proportionTax deferred proportion
Australian Equities 30% 5.0% 3.5% 60.0% - -
Property 10% 2.0% 7.0% - 0.0% 20.0%
Cash 5% - 4.5% - - -
Australian Fixed Interest 20% - 6.5% - - -
Overseas Equities 25% 7.0% 2.5% - - -
Overseas Fixed Interest 10% - 6.0% - - -

Fees per annum 1.5%
Holding Period in years 5.0
Turnover p.a. 20%

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