Beyond the super cap

Superannuation as a retirement vehicle no longer has the allure of that new-car smell. These days it’s clocked its share of kilometres, the paint job has a few scratches, and in July 2017 when the tax-free contributions were capped at $1.6 million, it was the equivalent of a rear-end prang. 

As the restrictions have tightened around superannuation, investors have turned to other alternatives to enhance their nest egg, including life insurance investment bonds. For high-net individuals who sit in a marginal tax rate at 30 per cent and higher, these products can provide an attractive, tax-efficient solution.

What’s an insurance investment bond? 

Life insurance investment bonds are a type of enforced investment plan that is set-up in such a way that ensures taxes are paid within the bond instead of by you. This means that any earnings accumulated during the life of the investment are not subject to any personal income tax. These bonds must come with a small life insurance component to provide the concessional tax treatment; otherwise, it’s treated like any other investment product. You can nominate who is to be insured as well as the beneficiary of the life insurance, but the focus of these products is on wealth creation, not protection.  

Most insurance bond products will offer a mix of investments, from blue-chip shares to property and cash, and it’s best to seek financial advice to ensure the investments within the fund are high-performing. The bonds can also be tailored to suit your risk profile.

Unlike superannuation, insurance bonds don’t cap the upfront investment; it’s limitless. It also doesn’t require you to reach the preservation age before a withdrawal can be made – which can be especially appealing if you’re an entrepreneur who cashed-out early and retired young. Currently, superannuation requires the investor to be aged at least 60 before they’re allowed to access their tax-free money, and this age restriction is likely to climb in the future.

What’s the catch?

Life insurance investment bonds require a long-term commitment, usually up to 10 years, which is referred to as the holding period or the eligible period. 

Any withdrawals made before this time attracts a tax liability and it’s scaled according to the length of the investment. For example, if you need urgent access to your cash and it’s within eight years, 100 per cent of all earnings made during that time will be slugged a 30 per cent tax offset (if the policy is held with an Australian insurer) but this reduces to two-thirds of all earnings in the ninth year.

And then, there’s the 125 per cent rule…

The 125 per cent rule

You can determine how substantial the initial lump sum investment premium will be, but every year after that, no more than 125 per cent of the previous year’s contribution can be deposited in the eligible period to keep the eligible period’s tax-free status.

If you make a contribution which exceeds this rule, it then resets the start date of the 10-year period, prolonging the time you can retrieve any profits without any tax liabilities. Similarly, skipping the yearly contribution will also guarantee that the term is reset if it’s followed by a payment the next year. 

It’s because of this rule that insurance investment bonds are not suited for everybody. People who are in a sound financial situation and who can make yearly contributions to maximise the investment’s potential are more likely to enjoy its benefits.

Not just for superannuation

While these types of investments are increasingly an alternative to superannuation, it’s also an appealing option for estate planning. The attached life insurance policy means that if the insured person dies within the term of the investment, it can be transferred to their nominated beneficiary, and without any capital gains consequences. The beneficiary must be mindful that the rules around the 10-year period remain, but all profits are theirs once it has come to term, so long as they were not on-sold the policy.

Saving for a child’s education is also another possibility through investment bonds. It’s one of the few ways to invest any money in a child’s name, without that child needing their own tax file number or for parent or grandparent to declare the earnings. Depending on the amount of money earned in the name of a child, other investments can be subject to high tax rates, between 47 per cent and 68 per cent. 

Full disclosure

Life insurance investment bonds will only grow in popularity because of the restrictions enforced upon super funds. However, financial advice is necessary to sift through the quality of the bonds available. Management fees for these products are hefty, in some cases, up to three per cent. There’s also a mix of local and offshore offerings, the latter bringing with it differing tax implications particularly for expatriates who may want somewhere to park their overseas earnings until their return home. 

Investors should also be conscious that the laws governing these bonds could eventually change. The ATO may decide to redefine what policies can receive a concessional tax treatment, leaving people in the lurch mid-way through the 10-year holding period.

A financial adviser will be able to do a full cost analysis before you sign the dotted line. As well as checking if there’s the necessary life insurance component that enables the tax concessions, they can implement a strategy to ensure you will comply with the 125 per cent rule. And finally, they will also be able to assess whether you can make the 10-year commitment to drive this investment vehicle and reap its full rewards.