Life Insurance Bonds
Overview
A bond, issued either as a life insurance or friendly society bond, is a simple investment structure used by single high-income earners or couples where both individuals are on a high marginal tax rate. Insurance bonds can also be a tax-effective and convenient way to set aside money for children.
The provider pays tax on the income and capital gains earned from the investment at the company tax rate of 30%. This creates tax advantages for some investors, particularly those on marginal tax rates above 30%. It should be noted that the provider (as a corporate) will not qualify for any discounts on realised capital gains. The full realised growth is taxed at 30%.
The advantage of an investment in these bonds is that the benefits are tax paid to the investor if withdrawn after the 10th anniversary, providing that annual contributions do not exceed 125% of the contributions made in the previous year. The proceeds are also tax paid upon death of the life insured.
If an investor makes a withdrawal before the 10th anniversary, all or some of the profits are added to taxable income for the year of withdrawal and taxed at their own marginal rate, but with a 30% tax offset applied. Thus, the taxable income is only growth received and is not grossed to include the offset value.
Given that the earnings within the investment are not included in the assessable income of the investor while it continues to be held, it will:
- not increase an investor’s taxable income for Medicare levy surcharge purposes, and
- not be included in the investor’s tax return,
Strategy Analysis
Growth on the insurance/investment bond is assessed as the investor’s taxable income in the year in which a withdrawal is made unless the 10 year period has been satisfied or the life insured has died, and the tax-paid status applies.
If growth is included in assessable income, the amount assessed depends on how long the investment has been running. Reductions start to apply after the 8th anniversary. The following scale applies:
| Date of withdrawal | Assessable amount |
| Withdrawals before the 8th anniversary | Growth withdrawn is fully assessable to the investor. |
| Withdrawals from the 8th anniversary until before the 9th anniversary | Two-thirds of the growth withdrawn is assessable to the investor. |
| Withdrawals from 9th anniversary until before the 10th anniversary | One-third of the growth withdrawn is assessable to the investor. |
| Withdrawals from the 10th anniversary | No portion is assessable to the investor. |
| Redemption upon the death of the life insured | No portion is assessable to the recipient. |
The rate of tax offset applicable to any assessable amount received by investors is 30%. Any unused offset can be used to reduce tax payable on other taxable income in that financial year. However, the tax offset cannot result in a tax refund or be carried forward. It also cannot be used to pay Medicare Levy.
Partial withdrawal
If a client partially withdraws from an insurance bond, the assessable amount is calculated per the formula below. For withdrawals made in the ninth or tenth years of the period, the earnings should be pro-rated as per the table above to determine the assessable portion.
Formula
(A/B) x [(B + C) – (D + E)]
Where:
A = amount withdrawn
B = surrender value of the policy immediately before withdrawal
C = any earlier amounts paid out under the policy
D = total gross premiums or investments paid into the bond from commencement of bond to date of withdrawal
E = previous amounts included in assessable income.
Adding more money
A client can invest additional amounts of up to 125% of the total amount invested in the previous year (anniversary year). These additional investments are treated for tax purposes as if they were invested on the date of the initial investment.
If the client contributes more than 125% of the amount contributed in the previous year, the ten-year exemption will recommence for the entire amount held within the bond.
If the client does not make any contributions in a year, they will not be able to make any further contributions in future years without resetting the 10 year period for the whole investment.
Client implications
Because the 30% offset is non-refundable, any excess offset (when combined with other non-refundable offsets) can be lost if the tax on taxable income is less than the sum of those offsets.
Generally, these investments are most suited to clients expected to have taxable income greater than $120,000 (also see comments above about the impact of the stage 3 tax reforms). Low-income earners would need to have a motivation other than taxation (e.g. estate planning purposes).
Insurance bonds may also become more attractive for high net wealth clients who have used up their super contribution caps and have further savings to invest in.
Educational bonds can also provide tax advantages if investing for a child’s education, particularly if the bond is classified under the tax rules for a scholarship fund.
Example – Tax offset for assessable proceeds from an insurance bond
Dorothy (age 50) has a taxable income of $120,000 before the redemption of an insurance bond in the sixth year. The redemption amount would include $10,000 assessable growth.
If she does not redeem the bond, her final tax liability is $31,867 (2023/24 rates).
If the bond redemption generates $10,000 of assessable growth and an offset of $3,000 (i.e. $10,000 x 30%), her final tax liability will be $32,767 (including Medicare levy and the tax offset).
The extra $10,000 attracts a marginal rate of 37% plus 2% Medicare, while the tax offset provides a reduction of 30%.
If the client is near retirement age (or is happy to give up access to their money until retirement), it may be more tax-effective to consider the merits of investing in super first before using an insurance bond. Super has an internal tax rate of only 15%. Super is subject to contribution caps.
Insurance bonds provide a tax-effective alternative to super for clients who want the flexibility to access money if desired or who have already used up their contribution caps.
Advantages of a bond
- simple structure,
- low tax rate if the investment is kept for 10 years (compared to higher marginal tax rates),
- if the tax rate of the investor falls below 30%, it may be advantageous to redeem the bond before the 10th anniversary to use the tax offset,
- an investment in a bond does not result in any amount being included in the investor’s assessable income until the bond is surrendered,
- it can be cashed at any time since there is no “preservation” restriction as there is with super,
- the bond can provide estate planning advantages as upon death it can be paid tax-paid to a nominated beneficiary,
- provides a simple structure for holding investments on trust for a child, even beyond the death of the original trustee (child advancement policies), and
- may help to reduce assessable income for aged care fee purposes (both residential and home care) but only if held through a family trust (care needed to weigh up all considerations).
Case Study
Frank invested $80,000 in a friendly society bond.
Frank has not made previous withdrawals from the fund. However, just after the 8th anniversary, Frank withdrew $20,000 for an overseas holiday. As a result, the account balance of the friendly society bond on that date was $105,000.
Frank’s current marginal tax rate is 47%.
The first step is to work out how much of the amount withdrawn represents growth in the investment. As the formula above shows this is done on a pro-rata basis.
= ($20,000 / $105,000) x [($105,000 + 0) – ($80,000 + 0)
= 0.190 x $25,000
= $4,750
Because the withdrawal is made between years 8 and 9, Frank must include $3,166 (i.e. $4,750 x 0.66) in his assessable income for the year. He is entitled to a non-refundable tax offset of $950 (i.e. $3,166 x 0.30).
When an investor’s marginal tax rate falls below 30%, the investor may wish to consider redeeming the bond from a tax perspective. Although the increase in the value of the bond will be included in the investor’s assessable income, this amount will not be taxed because of the 30% tax offset (Medicare levy may still apply). In fact, an excess tax offset will be created. This excess tax offset can be used to reduce the tax on other income and cannot be carried forward or refunded in cash.
The information contained in this article is general information only. It is not intended to be a recommendation, offer, advice or invitation to purchase, sell or otherwise deal in securities or other investments. Before making any decision in respect to a financial product, you should seek advice from an appropriately qualified professional. We believe that the information contained in this document is accurate. However, we are not specifically licensed to provide tax or legal advice and any information that may relate to you should be confirmed with your tax or legal adviser.
