Summary
Have you ever heard of an investment/insurance bond?
I probably did somewhere along the journey and most likely disregarded them as soon as I heard the word ‘bond’. But don’t be fooled by the name (like I was), there are a lot of advantages that these investments offer and in my opinion, are the best way to invest for children (your own or others).
But it doesn’t stop there. Investment bond can offer a legitimate tax effective alternative to the traditional ETF/LIC route that most Aussies adopt in the pursuit towards FIRE.
There are a few specific rules that need to be followed
In today’s episode, I chat to Catherine Van Deer Veen who is the CEO of Generation Life, an Australian investment and insurance company that’s been around for 15 years currently managing 1.3 Billion dollars for investors.
If you’re thinking about investing for your kids, nieces or nephews or are looking for a tax-efficient alternative investment product, this is the podcast for you!
In this episode, we talk about:
- What exactly is an Investment Bond
- What Generation Life can offer to investors
- The specific rules that you must follow in order to reap the full tax benefits
and much more
Hi AFB!
Really good episode, it’s been a long time coming to get some more detail on what the actual benefits are of investment bonds. I’ve been a longtime sceptic, but tried to keep an open mind to learn from what your guest had to say. And there were some points that I hadn’t considered before (e.g. you may want to control how much money and when the beneficiary can access), but at the same time there were some elements that don’t quite convince me. At the end of the day, it feels like a high-fee and high-complexity product, that is being sold as a tax minimisation strategy, but is only really worth the hassle in some very specific scenarios (if both you and your spouse are on incomes of >$180k each, or you want some specific vesting conditions – i.e. limiting when / how the beneficiary can access the funds). Curious to see you reflect on this point as I understood you to place a lot of emphasis on simplicity and low fees!
Disadvantages:
1) Cost: From what I understand this is a consistent theme. GenLife adds a 0.6% admin fee to almost all products (granted, there is a fee waiver for the 1st year, but if you’re making a long-term investment you should be considering the full 10-year horizon). This adds up to 0.7% total MER for the “cheapest” investment option, which compares with as low as 0.04% for VTS (18x difference). In the cost-conscious FIRE community we want to be absolutely sure that we value the benefits we’re paying for
2) Complexity / lack flexibility: Having yet another separate account creates an additional layer of complexity (although the separation could be beneficial if you want to make a gift you can “set and forget”). Also, if you want to take advantage of the tax benefits, you need to lock the money away for 10 years.
Advantages:
3) Tax savings (ongoing):
o Anyone earning <$37k is on a marginal tax rate <30%, so they would lose money on dividends they receive over the course of the investment bond (changes to franking credits may neutralise this disadvantage though)
o Anyone earning between $38-$90k or $91-$180k is saving 2.5% and 9.5% of dividends respectively. So on a $100k investment, assuming 4% dividend yield, your tax savings would be 0.1% ($100 / year) and 0.38% ($380 / year) respectively, which is less than the 0.6% admin fee you’re paying
o I agree that the product starts making sense for people on the top marginal tax rate (making more than $180k), but that is a small segment of the population and quite different to where it is getting pitched
o I would be interested to understand how the effective tax rate could get reduced to 22% as Catherine mentioned as that could change the calculation?
4) Tax savings (CGT at the end of 10 years):
o It’s true that you don’t pay CGT at the end of the 10 years, which is a benefit compared to normal investing, but you also don’t pay CGT if you’re doing “normal” investing and just never sell the shares. Or you could just buy AFI shares in your child’s name, turn on DSSP (so there is no unearned income for minors which has punitive tax rates) and let it compound until they are 18 and then gradually realise the capital gains while they are in uni (and have no/little income)
o There’s an interesting article from Macquarie comparing the benefits of investment bonds at different income tax rates, although the outcomes change if you change the assumption parameters https://www.macquarie.com/au/advisers/expertise/strategies/strategic-fit-of-investment-bonds-part-1/
5) Ability to segregate account, set conditions, etc: this could be useful if you’re giving this as a gift
Great critique, and further to your point about CGT, my understanding is that although there is no CGT payable after 10 years, all capital gains along the way are steadily taxed at 30%, within the bond.
KP is correct, there’s no PERSONAL CGT after 10 years however the structure pays 30% tax on realised gains and as such keeps a reserve on unrealised gains to fund the future liability.
Some great points. 0.6% fee compounded is a huge fee!
Hi Szilveszter,
You make great points. I really like the simplicity and ‘set and forget’ nature of investment bonds for kids. I think this is their greatest strength.
I agree that the higher fees add up and I don’t think we would invest for us personally. But we opened up an account for our nephew and it literally took under an hour and I really liked how you can specify when they can access the funds and what the funds have to be used for. The workflow is great.
“I would be interested to understand how the effective tax rate could get reduced to 22% as Catherine mentioned as that could change the calculation?”
7.42 min. Pays Fixed Company Tax Rate 30% but can pass franking credits to the Bond Holder. Advantage relative to other investment companies. Again 22.17 min
A Super Annuation Fund/Family trust and/or Low tax paying Beneficiary such as a Spouse or grandparent can easily benefit more from the frank credits with a starting marginal tax rate much lower than 30% p.a.
23.59 min Super 15% is more effective than Investment bond if you can max your first $25K contribution.
15.42 min “Investment Bond passes wealth to a Grandchild”. A Testamentary trusts gives greater flexibility and avoids the unearned income child tax rate of 66%.
24.32 min Friendly Society Bonds hard coded in legislation, so as Investment bonds pay tax,
25.11 Not as big a tax avoidance strategy as Family Trusts, Negative Gearing or superannuation for that matter.
These three strategies are still currently legal and effective at reducing tax for all taxpayers and should be considered well before you look at the crumbs offered by Investment Bonds.
The fatal flaw is progressive “Tax Paid” nature of the Investment Bond each year crimps the compounding return benefit of holding an identical underlying managed fund by paying out 30% of the return each year as tax, rather than waiting 10 years and paying tax on the significantly larger end amount.
https://www.moneysmart.gov.au/tools-and-resources/calculators-and-apps/compound-interest-calculator
Assume you invested A$10K lump sum into an investment bond that has an underlying return of 7.00% p.a. but must pay out 30% as tax each year. Hence, 4.9% p.a. returns.
After 10 years, you receive a $16,134-00 after tax lump sum. $6134-00 after tax capital gain
Assume you put $10K lump sum into an index fund returning 7.00% p.a. and have to pay capital gains tax at the end.
After 10 years, you receive a $19,672-00 pre tax lump sum. $9672-00 pre-tax capital gain.
A difference of $3538 or 57.68% more for exactly the same underlying investment!
This does not count their management fees on top of the underlying funds management fee.
https://www.budget.gov.au/2018-19/content/factsheets/7-pitp.html
Only 5% of Australians pay the A$180K+ Tax rate on their income.
Of those 5%, a large percentage could utilise a combination of Superannuation, Family trust, Low-income spouses to neutralise the maximum capital gains tax of 22.5% of the top marginal tax rate to avoid losing more than 58% of investment in fees and taxes over the last 10 years holding an investment bond!
Thanks for comment Keith.
Interesting thoughts. How highly do you rate simplicity? There’s a world of difference between setting up a trust compared to an investment bond.
I value simplicity so much that I sold all my unlisted and listed manage funds so that I didn’t have to wait two months for the fund manager to break down the capital gains and other components of a distribution in a tax statement two months after the end of financial year.
I am not advocating Family trusts as the first alternative to Investment Bonds for investing on behalf of nieces and nephews.
It is one of three potential options that is far more tax effective than investment bonds which I deem a last resort investment to doing nothing!
Far easier option is to take Szilveszter’s advice.
“you could just buy AFI shares in your child’s name, turn on DSSP (so there is no unearned income for minors which has punitive tax rates) and let it compound until they are 18 and then gradually realise the capital gains while they are in uni (and have no/little income)”
http://www.afi.com.au/Investing-for-Children.aspx
You get the full benefits of tax free compounding without the Investment bonds compulsory annual tax drag of losing 30% of returns in taxes, not to mention ongoing management fees on top of the underlying funds management fees.
A low income grandparent, spouse means that any distributions from AFI would be better sheltered than the straight up 30% loss in taxes plus other fees. As the account is registered as held in trust for the child, it can be transferred capital gains tax free to the child when they are older.
As 23.59 min mark she admits Super paying 15% is a better choice than the 30% tax of the Investment Bond. So why would a lower tax paying spouse or grand parent paying tax at less than 30% not be the better choice?
Using the Compounding interest calculator, the net effect after 10 years is the Investment bond absorbs over 50% of the potential capital gains in taxes and charges for an investment in an IDENTICAL managed fund/ETF/LIC.
I am also a willing victim of the “Lazy Investor Tax”, but even I would baulk at losing over 50% of my investment after a decade just to keep it “Simple”!
Yeah but if you start buying in the kid’s name you have to:
1. Set up an account for the child
2. Lodge a tax return each year for the child
3. Keep track of the DSSP component since when you sell it becomes an accounting nightmare
There’s also the element of a gift or surprise taken away. If the child owes the shares from the get-go, they can technically do what they want with them.
Everyone is different but I want the investment I have set up for my nephew to be specifically used for a house deposit. This is a gift for them in the future.
The three options you’ve outlined above might be pretty straightforward for people like you and me who are into this stuff, but 90% of people are going to give up as soon as they don’t understand something.
There’s no ‘right’ answer and total return is not everything.
“Yeah but if you start buying in the kid’s name you have to:
1. Set up an account for the child”
Yes. Just like you had to setup something with GenLife with your nephew as beneficiary. Any financial product must have some documentation to be legally valid.
“2. Lodge a tax return each year for the child”
No. Using a DSSP means you don’t have to file a tax return.
“3. Keep track of the DSSP component since when you sell it becomes an accounting nightmare.”
No. You forfeit the dividend and any franking credit to get no consideration bonus shares which form part of the cost base of the original purchase price and date. So no book keeping of additional units over the life of the DSSP.
http://www.afi.com.au/_uploads/242155AFIC_IFC_brochure_Aug_2017_P4.pdf
p.6 As a result, AFIC believes that for Australian resident capital
account investors the receipt of such ‘bonus’ shares should not,
in general, be subject to Australian income tax at the time the shares
are issued.
Importantly, the outcome for shareholders that participate in
the DSSP is that the cost base of the existing shares is spread
across the existing shares and the new shares issued under
the DSSP. The DSSP shares are regarded as having been acquired
at the same time as the existing participating shareholding.”
So this is a one off gift to your nephew with no tax consequences for you or him as you are not receiving income but accepting additional units which are part of the original cost base.
_____________________________________
“There’s also the element of a gift or surprise taken away. If the child owes the shares from the get-go, they can technically do what they want with them.”
You can nominate the Grandparent as a Trustee if you have concerns over the use of the gift when it becomes due.
“Everyone is different but I want the investment I have set up for my nephew to be specifically used for a house deposit. This is a gift for them in the future.”
The control aspect can be addressed on p.5. Low tax paying guardian as trustee.
“The three options you’ve outlined above might be pretty straightforward for people like you and me who are into this stuff, but 90% of people are going to give up as soon as they don’t understand something.
There’s no ‘right’ answer and total return is not everything.”
Lets not confuse the matter by focussing too much on the more advance Trust (Family and Super) structures which would be in the wheel house of the ideal user of investment bonds (ie. DINK earning more than $180K+ income with no low income parents).
Focus on comparing the AFI DSSP held by a Low tax paying Grand parent as trustee to ensure that the gift of shares to a child is not squandered vs. the Investment Bond Option.
“There’s no ‘right’ answer and total return is not everything.”
If you remove your incorrect perception that the AFI DSSP is not as simple and tax effective to implement and administer as your preferred Investment Bond option.
You should consider the impact of fees and taxes on the total return on his future house deposit.
Hi Keith,
Very persistent! I like your fighting spirit 👊
If you are purely talking about going AFI and DSSP (you did mention three options before) then…
1. I’m guessing you have never set up an insurance bond before? If you have you’d know it’s considerably easier and more straightforward vs opening an account and turning on DSSP.
2. For DSSP only you’re correct. Do they still need a TFN though? I’m not sure on that
3. Are you assuming you never add to the investment over time? Also, DSSP works really well if you never sell. Far less efficient if you sell through the cost base reduction. And in my scenario (house deposit) my nephew would indeed be selling. There are tricks around the CGT component by potentially sell some units in low to no income years (maybe at uni) but now we’re getting more complex and remember my argument was always based on simplicity and never total return. A vesting date and automatic transfer is keeping it pretty simple IMO.
I couldn’t find anything on page 5 of the AFI document about estate planning. Page 5 refers to different tax considerations, not what the asset has to be used for.
Estate planning can be set up in insurance bonds without the need of a trust.
At the end of the day, how complex or simple something is comes down to the individual. It’s subjective and there’s never going to be one right answer for everyone.
Let’s just agree to disagree.
Was a fun back and forth as always Keith 🤙
Our disagreement is due to the product name potentially misleading a buyer of wealth creation investments to invest in a wealth preservation product and wonder why it failed to grow.
If you invest in a government backed at call savings account, you accept low interest to ensure return of your savings.
In contrast, buying Bit Coin means you risk total financial loss in the hope of life changing capital gains.
The term “Investment Bond” was conjured up by the Life and Friendly Society marketers at the same time “Insurance Brokers” decided to rebrand themselves as “Financial advisors” despite their lack of training, knowledge and legal license to sell anything but Insurance policies.
Investment Bonds are regulated under the insurance act because their original label was
“Market linked insurance bond”.
This is a truer label for this product’s intended purpose of receiving a slightly higher return for a slightly riskier product than straight insurance policy that provides no return at the end of the policy if you never had to claim.
Investment Bonds as a standalone wealth creation investment is mediocre because of the ongoing costs of management and taxes over the life of the bond.
However, it delivers wealth preservation by guaranteeing certainty of payment by absorbing a large portion of the investment returns to fund the administration and taxation obligations associated with offering this insurance product.
While I invest for growth, I always pay premiums for health and car insurance.
I don’t expect to get rich from paying my health and car insurance premiums as it is merely a wealth preservation tool.
Calling something one thing when it really is another is problematic.
It’s how CBA can charge premiums for income protection insurance on credit cards to unemployed people who could never collect on the policy.
If people were to educate themselves on the pros and cons of a product like an “Investment Bond” they would be more likely to gain the outcome they desire over the long run.
Hi where can I get a transcript of the podcast?
Thanks
Sorry J.D. I had some trouble with the transcription. I’m not sure if I’ll be able to post it 🙁
https://www.moneysmart.gov.au/tools-and-resources/calculators-and-apps/compound-interest-calculator
Assume you invested A$10K lump sum into an investment bond and contribute $1000 per annum that has an underlying return of 7.00% p.a. but must pay out 30% as tax each year. Hence, 4.9% p.a. returns.
After 10 years, you receive a $28,654-00 after tax lump sum. $8,654-00 after tax capital gain
Assume you put $10K lump sum and contribute $1000 per year into an index fund returning 7.00% p.a. and have to pay capital gains tax at the end.
After 10 years, you receive a $33,488-00 pre tax lump sum. $13,488-00 pre-tax capital gain.
A difference of $4834 or 55.86% more for exactly the same underlying investment!
Still beating out the total returns from the tax paid Insurance Bond after 10 years.
“I would be interested to understand how the effective tax rate could get reduced to 22% as Catherine mentioned as that could change the calculation?” – Szilveszter
7.42 min. Pays Fixed Company Tax Rate 30% but can pass franking credits to the Bond Holder. Advantage relative to other investment companies. Again 22.17 min – Catherine Van Deer Veen (CVDV)
23.59 min Super 15% is more effective than Investment bond if you can max your first $25K contribution. – CVDV
15.42 min “Investment Bond passes wealth to a Grandchild”. A Testamentary trusts gives greater flexibility and avoids the unearned income child tax rate of 66%. – CVDV
24.32 min Friendly Society Bonds hard coded in legislation, so as Investment bonds pay tax, – CVDV
25.11 Not as big a tax avoidance strategy as Family Trusts, Negative Gearing or superannuation for that matter. – CVDV
https://www.budget.gov.au/2018-19/content/factsheets/7-pitp.html
Only 5% of Australians pay the A$180K+ Tax rate on their income.
These three strategies are still currently legal and effective at reducing tax for all taxpayers and should be considered well before you look at the crumbs offered by Investment Bonds expensive management fees and taxes.
Thanks to everyone who has commented on this podcast. I’m pleased that it’s generated so much discussion.
Let me answer some of the questions, and add that this information is not intended to be personal advice. We always suggest people seek advice on their own personal situation before making any investment decisions:
Firstly, there are many investment structures available to customers to manage their investments and their tax affairs. An investment bond is just one of these vehicles and we do not suggest it should replace other strategies, but offer it for consideration as part of a balanced portfolio depending on what is important to customers.
The investment bond is most tax-effective for customers who are on a higher marginal tax rate. As mentioned, once the investor is paying over 30% marginal tax rate then the investment bond pays less tax on investment returns than the individual in most instances. All returns within a bond are treated as income. Even as capital gains are made within the investment, these are treated as income.
An individual, directly holding an asset which makes a capital gain who holds the asset for more than 12 months is entitled to a 50% on these capital gains, making the effective tax rate for these capital gains 23.5% if they’re on the highest marginal tax rate of 47% (including Medicare Levy). This is where the investment bond pays a higher rate of tax than the individual.
Returns provided by any investment fund contain elements of franked income, non-franked income, discounted and non-discounted capital gains. In general the concept is correct in that the higher the proportion of discounted capital gain component, the less attractive an investment bond looks compared to direct ownership.
If an investment return was made up entirely of 100% discountable capital gains, the following would be the effective tax rates paid…
Individual @ 47% MTR 23.5%
Bond @ 30% 30%
If an investment return was made up entirely of non-franked income, the following would be the effective tax rates paid…
Individual @ 47% MTR 47%
Bond @ 30% 30%
At the other end of the spectrum if an investment return was made up entirely of 100% franked dividends, the respective effective tax rate on the earnings received would be…
Individual @ 47% MTR 24.3%
Bond @ 30% 0%
Here’s the calculation
Individual Investment bond
Franked earnings $70 $70
Grossed up amount $100 $100
Tax rate applicable 47% 30%
Tax payable $47 $30
Franking credit -$30 -$30
Tax paid $17 $0
Tax paid 24.3% 0.0%
(as percentage of earnings received)
So the answer would lie somewhere in the middle, depending on the makeup of the end return.
To provide more context on the tax payable in the funds:
The bond pays tax of 30%. Any of the income received which is subject to franking is applied to the investment. So for investments in Australian shares, income received can have a tax paid tax rate of less than 30%. The average actual tax paid on Australian share options within our bond over the last 4 years was 12.3%.
It’s worth mentioning that one would struggle to find an investment that provides 6.7% growth, together with 3.5% income over a 10 year period. That is, that whenever investments inside trusts are turned over, the capital gain needs to be distributed (as income) in the year in which it is realised. Over 10 years, this always skews the total return profile more in favour of the income side. It’s also important to remember that paying tax annually means there’s less left to invest. The compounding effect of paying a lower amount of tax each year and having the difference remaining invested can be substantial.
I would encourage anyone who wants to compare direct ownership of assets to investments inside of an investment bond to seek individual tax advice, as it’s not practical to explain many of these complexities in a written summary.
People have rightly talked about fees as an issue for investments. I agree that fees are a very important consideration when it comes to investing. At Generation Life we pride ourselves on having top quartile fees, and we are the only provider to currently have a waiver on the first year’s administration fee. Many of our investors choose low-fee options on the menu such as BlackRock or Vanguard. Clearly, accessing an ETF directly is the cheapest option for investors (VTS at 0.04% p.a.). However, for investors who want to invest in a diversified option such as Vanguard Balanced or Growth, which are not available as an ETF, they would pay 0.90% p.a, to invest directly with Vanguard. At Generation Life, investors have access to wholesale pricing through our platform, making the total fee for the Vanguard Growth Index Fund 0.69% p.a. When you consider the tax advantage for investors which can add a boost to after-tax and after-fee performance then I am confident we have a compelling value proposition that stacks up.
Family trusts are a well established vehicle for managing tax effectively. They do come with some complexity and cost to establish, and once all beneficiaries are on top marginal tax rates, they do not offer tax-efficiency as all income must be distributed each year. Unlike other investments such as shares, managed funds and term deposits, investments bonds do not distribute taxable income. Having a discretionary or family trust invest in an investment bond means there is no distributable income generated from the bond investment. After 10 years, any proceeds from a withdrawal from an investment bond, paid to beneficiaries will be tax free, regardless of the individual marginal tax rate of the beneficiary. There’s also the benefit of not needing to keep detailed records and tax reporting – the investment bond doesn’t distribute income and there’s no capital gains tax paid when it’s redeemed. You don’t even need to provide a tax file number.
Negative gearing is still allowable (until any changes under Labor!) and another tax-effective strategy. And one that I use personally. It does only deliver a tax benefit when the cost of borrowing exceeds the income generated from the asset. Clearly an investor must rely on capital growth to make a return on the asset to make the losses on interest worthwhile.
We suggest that investment bonds are an attractive option for investors who are paying top marginal tax rates, have capped out their super contributions and are looking for a tax-effective home for their investments. Dexx&r have estimated with the tightening of tax concessions on super, there is $18bn of money that used to go into super, now locked out. We suggest that bonds have a good place in portfolios (not the entire place), for tax effectiveness and for control of wealth transfer.
Again, appreciate the opportunity to ‘meet’ the listeners and give more information on bonds.
Great podcast dude.
I have a 7 year old son myself so I found this very useful!
At this stage we just have a small portfolio in the wife’s name.
One day when the income is significant, we will just spend it on our son.
School, Uni, Travel, Sport etc etc.
Keep it up
Hey Aussie Firebug,
What an interesting podcast exploring a lesser known investment vehicle. I first came across investment bonds in Scott Pape’s book but was left with heaps of questions. This interview helped clear a few them up.
Good work on sourcing a knowledgeable interviewee, and thanks to Catherine if you are reading this.
Cheers,
Alex
Hi Alex, glad you enjoyed it. Thanks for listening. If you have further questions, the team at GenLife are very knowledgeable and happy to help.
Kind regards
Catherine
Thanks Alex. Glad you enjoyed it 🙂
Hi – I came across this article and would love to get your feedback. Do you agree with the comment that it is actually less tax effective in all situations than direct ownership? Thanks!
https://nakedinvestor.com.au/f/test
Hi, great podcast. One question which I do t think was answered clearly in the interview is how capital gains are taxed during the 10year period and beyond? I understand (or at least think I do) regarding the dividends but didn’t catch how capital gains are (potentially) taxed?
Thanks
Hello Mitch, thanks for your question. The capital gains are treated as income within the bond and are taxed at a maximum rate of 30%. These gains can be then offset by franking credits or by harvesting other losses within the bond which can bring the effective tax rate down to as low as 10% in some instances.
A personal investor incurring capital gains pays tax at 50%, but if they hold the asset more than 12m are entitled to a 50% discount, bringing the effective tax rate to 25%. These gains can be offset by other capital losses, but not by income benefits such as franking.
Hope this answers your question.
Kind regards
Catherine
CEO – Generation Life
Hi Catherine,
Why are there capital gains being triggered along the way if the investment is being held for 10 years?
Thanks
Can someone explain why you would use Generation life to manage your vanguard portfolio instead of doing directly through them and reinvesting the dividends? There are n dividend payments with gen life so, in ten years, how can you generate an income to retire?