Investment bonds can be an effective strategy for people subject to marginal tax rates above 30%, writes David Barrett.
As the 2017 federal budget dabbled in housing affordability, sought to reign over federal spending on higher education, and sought to get big banks and large multinationals to fund a series of promises. From spending through new and increased taxes, there were still many elements that would allow financial planners to help their clients navigate the new measures in the budget.
The reduced non-concessional contribution limit of $ 300,000 over a three-year period starting July 1, 2017 limits the retirement pension as an option for large financial gains. As a result, many financial services professionals are looking for retirement pension alternatives for clients with large sums to invest.
Life insurance and friendly corporate bonds (investment bonds) are worth considering in this context, as the underlying income tax is based on the corporate tax rate. , currently 30 percent.
When considering investment structure alternatives, assumptions of expected gross earnings and the marginal tax rate of a client (and / or that of their spouse) are useful starting points.
Projection rate assumptions and marginal tax rates
Suppose the underlying investment is a balanced portfolio of assets diversified across six asset classes: cash, Australian fixed interest, international fixed interest, Australian equities, international equities, and real estate.
The indicative projection rate after fees for the portfolio is 6.7% per annum, composed of 3.3% income (including charge-off credits) and 3.4% capital growth (assuming a turnover of 20% of assets per year). Refer to the projection rate assumptions on page 34 for more details.
Figure 1 shows the after-tax return for various marginal tax rates (MPRs) based on the illustrative after-expense projection rate above, assuming capital gains tax (CGT) reductions are made. apply (50% in personal name, 33 and 1/3 per cent in retirement pension and zero for legal persons).
Consider a $ 100,000 investment over 20 years by Billie, whose taxable income exceeds $ 87,000 but is less than $ 180,000 – her marginal tax rate is 39%, including Medicare.
If Billie were to invest on her own behalf, $ 100,000 would increase to about $ 258,000 over 20 years, compared to $ 316,000 in superannuation accumulation, or $ 58,000 more. In today’s dollars (assuming an inflation rate of 2.5% per annum), Billie’s investment will be valued at $ 158,000 (in personal name) or $ 193,000 (in super).
Profits from investment bonds are taxed within the bond, before redemption, at the 30 percent corporate tax rate. If an investment bond is held for 10 years or more, the net profits (after paying tax at the corporate rate) are not subject to any additional tax when collected by the owner of the bond. Thus, the overall tax rate paid on income is 30 percent.
This may sound interesting compared to the marginal personal income tax rates of 34.5, 39 and 47 percent. However, CGT discounts do not apply to capital gains realized under an investment bond structure, so the after-tax rate of return is reduced.
Chart 1 shows that the after-tax return on an investment bond would be 4.8% per year if the illustrative projection rate after fees is 6.7% per year. This result is only preferable to a personal investment at the highest marginal personal tax rate (after-tax return of 4.5% per annum), so that an investment obligation would only appeal to people. those with taxable income of $ 180,000 or more. A better result will be obtained by investing in a client’s personal name at all other marginal tax rates.
Example: Billie (continued)
If Billie invested $ 100,000 in an investment bond subject to the same pre-tax returns as described above (6.7% per annum), it would rise to $ 255,000 after 20 years, or the equivalent of $ 155,000 in today’s dollars.
The results of personal investment options and investment bonds are shown in Table 1.
Note that it has been proposed to reduce the corporate tax rate to 25 percent by July 1, 2026 for all legal persons. An amending bill is currently before Parliament which had not been passed at the time of writing. For large entities (total turnover of over $ 1 billion), the 30% reduction will begin to occur from July 1, 2023, if the proposed legislation becomes law.
Investment bonds will become relatively more attractive if the corporate tax rate is reduced to 25 percent. The after-tax return on the investment obligation described above would be 5.1 percent per year (see Chart 1) if the illustrative projection rate after fees is 6.7 percent per year.
That’s a better result than investing personally at Billie’s marginal tax rate of 39 percent, and also exceeds the result if her marginal tax rate was 34.5 percent. Based on the return assumptions used here (see Projection Rate Assumptions), the investment obligations would be of interest to clients with taxable income of $ 37,000 or more.
In summary, until the proposed reductions in the corporate tax rate occur (if any), the investment requirements for a âtotal portfolioâ approach (based on the stated return assumptions) are. attractive if the only alternative is to invest personally where the highest marginal rate (47 percent) applies.
The attractiveness of investment bonds is reduced by the absence of a CGT discount. The absence of a CGT haircut is less important if the underlying assets are predominantly income producing, such as cash and fixed income securities (âdefensive assetsâ).
It follows that structuring defensive assets into an investment bond and growth assets in a person’s name, where the CGT 50 percent haircut may apply, can be an effective strategy.
The balanced portfolio described above consists of 35 percent defensive assets (cash and fixed interest) and 65 percent growth assets (Australian and international stocks and properties). Divide them into separate structures i.e. defensive assets into an investment bond (30% corporate tax rate) and personal growth assets (39% marginal tax rate ), would result in an after-tax return of 5.2 percent per year over 20 years if the illustrative projection rate after fees were 6.7 percent per year.
Example: Billie (continued)
Consider a $ 100,000 investment over 20 years by Billie whose taxable income exceeds $ 87,000 but is less than $ 180,000 – her marginal tax rate is 39%, including Medicare.
The results over 20 years in future values ââand in today’s dollars for three investment options (personal name, obligation to invest in the whole portfolio and divided portfolio as described above) are presented in the table. 2.
The divided wallet is the best outcome for Billie. Interestingly, it produces a better result than investing in someone’s name where the 34.5% marginal tax rate (including Medicare levy) applies (taxable income between 37 $ 000 and $ 87,000).
In addition, this result is consistent when varying the yield assumptions up and down by one percent per year.
There are advantages and disadvantages to using investment bonds with a period of 10 years or more. The loss of any discount on capital gains is a deterrent.
However, the use of investment bonds for primarily income-producing assets can be an effective strategy for those subject to marginal tax rates above 30 percent.
In addition, if the corporate tax rate is reduced by 30 percent, the relative attractiveness of investment bonds will increase further.
Note that this article has not taken into account the tax implications of redeeming an investment bond in the first 10 years, nor the effectiveness of investment bonds used for educational purposes. These are subjects for another day.
Projection rate assumptions
The 6.7% pre-tax after-expense projection rate of 6.7% per annum used in this article is based on asset class weights, long-term income and capital growth projection rates, and other assumptions. in the table below.
These rates are not guaranteed, are provided for information only and may differ from actual results. Projection rates are not intended to be and should not be relied upon when making a decision regarding any particular financial product. Before making any financial decisions, you should seek personal financial advice from an Australian financial services licensee.
David Barrett is the head of technical services for Macquarie.