What are Investment Bonds? How do they work? And who should be investing in them?
This article is a complete guide if you're considering an Investment Bond to invest and diversify your income streams. We will cover all the basic information: starting with a proper introduction, Investment Bond options, recurring terminologies, risks, FAQs, and other important details that will be useful as you go further into the topic.
Bond? Investment-grade Bond? Investment Bond? James Bond?
If you're on the path to educating yourself in finance, you may realise that we're not good at titling financial products. Take the good old Investment Bond, for example: you may expect that it is the same as other bonds, but in Australia, this particular name relates to a very different product. For the purposes of this article, we are discussing Investment Bonds, but here's a comparison to make things a little clearer for you:
What's a Bond?
A 'bond' is a special kind of loan where you lend money to a corporation or the government. In return, the bond issuer promises to give you the "face value" back on a stipulated date in the future, plus the interest payments (also called coupon payments) on your loaned amount (sometimes paid at regular intervals, other times paid at the set date the loan is to end, or 'mature').
The interest rate you receive typically increases as the borrower becomes riskier. Interest rates rise when you lend to a small private company and lower when you lend to a stable entity like the government. The more secure lenders are typically regarded as 'investment-grade' bonds, so an 'investment-grade bond' is simply referring to a bond where money has been loaned to a stable borrower.
What are Investment Bonds?
In Australia, an 'Investment Bond' is a product that you can invest into, which carries a number of unique benefits and features. Similar to a superannuation fund, the Investment Bonds is simply a structure that holds your financial investment (account balance) and allows you to invest the money in line with the investment options available.
Just like superannuation, Investment Bonds are tax-paid investments, meaning all the taxing is done and paid within the Investment Bonds itself and doesn't form part of your personal tax return. But unlike superannuation, there are no age-based limitations on your withdrawals and you're ultimately able to withdraw some or all of your investment at any point. There are also some highly beneficial tax features to Investment Bonds, but we'll get to that a little later.
Who is James Bond?
James Bond is a fictional British secret agent created by novelist, Ian Fleming, and the star of many large-budget films. We prefer the early ones and then some of the later ones. Moonraker was ridiculous. Let's get back to Investment Bonds.
How Does an Investment Bond Work?
An Investment Bond is a long-term investment you can set up via several product providers. The provider will invest your contributions based on equities and other assets of your choosing: cash, fixed interest, shares, property, or a range of diversified investment options available within the product.
Note: When investing in an Investment Bond, it's always best to consider a large lump sum for long-term investment. Investment Bonds that are retained (and well-managed) for at least 10 years will have no Capital Gains Tax (CGT) payable upon redemption - which can be a massive tax saving versus a traditional investment especially if you're a high-earner individual.
Key Features of Investment Bonds
What are the key features of Investment Bonds? Here are some of the main advantages you should know about:
Tax Efficiency for High-Income Earners
Investment Bonds are internally taxed at a flat rate of 30%. So for an Investment Bond that receives $20,000 income in any given financial year, 30% (or $6,000) is likely to be taken as tax, with the other $14,000 growing the value of your Investment Bond. This tax rate can be highly advantageous if you're in a higher tax bracket, with a marginal tax rate above 30% - typically a taxable income of over $45,000pa. For this reason, Investment Bonds can be a tax-effective choice for high-income earners.
Just like your traditional investments or superannuation, Investment Bonds can take advantage of franking credits to lower the internal rate of tax that is paid each year. Franking credits arise when a company pays a dividend to shareholders with money that has already had income tax deducted. The 'credit' is therefore designed to avoid you paying tax twice on the money (once before it was paid to you, and then again when you receive it). This additional financial benefit can be utilised to reduce the overall tax rate of Investment Bonds to as low as 15% instead of the traditional 30% rate mentioned above.
We mentioned before that Investment Bonds are tax-paid investments. This is because an all the returns you earn from the Investment Bond while it remains invested - and even upon withdrawal after the ten-year tax period – are not counted towards your assessable income. This can create a significant tax advantage over time.
No Capital Gains Tax (CGT) if held for over ten years
As mentioned earlier, Investment Bonds that are retained (and well-managed) for more than ten years will have no Capital Gains Tax (CGT) payable upon redemption. The eligibility requirements are two-fold: you must have an Investment Bond start date of more than ten years since the date of your withdrawal, and you must have adhered to the 125% rule throughout the life of the Investment Bond.
The 125% rule on contributions
Subject to the limits of your specific Investment Bond provider, you can make regular ongoing contributions to your Investment Bond at any frequency or amount. You must, however, remain very mindful of the 125% rule - which dictates that you can't contribute more than 1.25x or 125% of your previous year's contributions. The implications of this rule are severe, as breaching this rule will result in the 10-year clock (for CGT-free withdrawals) restarting.
For example, an Investment Bond owner who made contributions of $10,000 in a given year would be limited to $12,500 the following year while protecting their ten-year rule, which is highly advisable. If they made the $12,500 contribution, their limit the following year would be $15,625 ($12,500 x 125%). If you intend to make ongoing contributions, it's therefore critical to manage a regular payment: if you make no contributions for any given year, you're effectively 'locked out' of contributing to the Investment Bond without breaking the ten-year rule (as 125% of your last year's contribution of $0 = $0).
Stability Amid Regulatory Changes
Many investors are apprehensive about putting money into superannuation because of the ever-changing superannuation rules. Investment Bonds have largely remained unaffected by these frequent changes, providing an added layer of financial stability.
Tax-Free Estate Planning
Investment Bonds allow you to nominate a beneficiary to receive the funds upon your death. In the unfortunate event of your passing, the proceeds from the Investment Bond will directly go to your nominated beneficiary, bypassing the complexities of estate distribution. Critically, this payment is usually tax free offering a substantial saving when compared with other investments, which would require tax to be deducted before a payment is made.
Diverse Investment Options
With an Investment Bond, you're not limited to just one choice. Good quality Investment Bond providers offer a broad spectrum of investment options to cater to different credit risk profiles and investment goals.
Asset Protection against Bankruptcy
Life has its uncertainties, especially if you have higher risk exposure, such as being a business owner. In bankruptcy, creditors cannot access your Investment Bond assets. However, transfers to an Investment Bond, which can be shown to have the specific intent of evading creditors, may be available to the trustee in bankruptcy.
Who Should Consider an Investment Bond?
So, who should consider adding an Investment Bond to their financial portfolio? Here are some people who should look into Investment Bonds.
- High-Income Earners: Individuals with a marginal tax rate higher than the tax rate on the Investment Bond (typically around 30%) stand to benefit from this investment type. That's because returns from the Investment Bond are internally taxed at a rate of 30% or lower, making it tax-effective.
- Long-Term Investors: Beyond ten years, you no longer pay personal tax on withdrawals. This added break makes this form of investment attractive.
- Estate Planners: Individuals who want a straightforward way to pass on wealth can use Investment Bonds. The proceeds bypass the estate and go directly to the beneficiaries without incurring tax.
- Parents & Grandparents: Investment Bonds can be an excellent tool for those wanting to save for their children's or grandchildren's future. They can be set up in the child's name and let it grow substantially over the years.
- Individuals Worried about Superannuation Limits: For those who have maxed out their super contributions or are concerned about superannuation rules, Investment Bonds provide an alternative tax-effective investment vehicle.
- Asset Protection Seekers: People in professions with higher litigation risks (e.g., doctors, lawyers) might opt for Investment Bonds, as they generally offer some protection against creditors.
- Flexible Investors: Switching between investment options within the Investment Bond usually doesn't trigger a personal capital gains tax event. So, Investment Bonds are excellent options for those looking for flexibility when they want to adjust investments without immediate tax implications.
- Individuals Planning for Future Income Streams: By setting up regular withdrawal plans after 10 years, individuals can establish a tax-free income stream from Investment Bonds.
Frequently Asked Questions About Investment Bonds (FAQs)
Are Investment Bonds a good investment?
To answer the question plainly: Yes, Investment Bonds are good investments.
Individuals use Investment Bonds to diversify their income streams and grow their wealth over time. Investment Bonds can be great if you're saving for your retirement and future projects, conserving existing assets, and diversifying your investment portfolio.
What is the best Investment Bond?
There's no "one-size-fits-all" answer to this question. The choice depends on your personal financial goals and risk tolerance. Results may vary for each investor depending on the circumstances present in the life of your Investment Bond, so we recommend that you speak with a financial advisor.
Are corporate and government bonds like Investment Bonds?
In Australia, corporate and government bonds have little overlap with Investment Bonds.
Companies issue corporate bonds to raise money for operations or expansion. Federal or state governments issue government bonds to finance public projects or manage monetary policy.
A corporate bond generally carries an interest rate risk linked to the financial health of the issuing company, thus, they typically offer higher yields as compensation.
On the other hand, government bond funds are regarded as safer investments because they're backed by the government's creditworthiness, resulting in them usually having lower yields. Australian government bonds often come in two types: exchanged-traded Treasury Bonds (eTBs), which provide fixed interest payments, and exchange-traded Treasury Indexed Bonds (eTIBs).
Both bond types may have credit ratings, provide periodic interest payments, and have set maturity dates. However, the primary distinction lies in their purpose and issuer. Investors should be mindful of these differences when considering their investment choices.
Final Thoughts About Investment Bonds
Investment Bonds can be a fantastic investment for those looking for a more tax-effective way to build their long-term wealth. The money within an Investment Bond is typically readily available and can support a more diversified financial asset base.
Ensure that you have enough knowledge and understanding about Investment Bonds before you lay out your initial investment. This way, you can avoid wasting your hard-earned money and, most importantly, your time. Any investment must suit your best interests and help you meet your goals.
If you still have questions and require further understanding about Investment Bonds even after reading this article, a financial advisor could help you.
Let Northeast Wealth Australia help you with your investment management so you can confidently make informed choices with a strategic direction and step-by-step guidance. We'll help put your goals and plans into action, starting now.