Australian Investment/Insurance Bonds

Investment/insurance bonds are an Australian investment vehicle, which is a bit like a superannuation fund but actually is formally a type of life insurance. You make an investment like in a super fund, but instead of earnings being taxed at 15% they are taxed at the corporate income tax rate, which is 30% currently. If you withdraw the money after 10 years, no additional tax is payable. This can be a good idea in two cases:

1. If you are in a high tax bracket so that additional investments are taxed at up to a 47% marginal tax rate and you either have maximized your superannuation contributions or want the flexibility to get the money out before you retire.*

2. You want to invest in your children's name. Investments for children in their name are subject to very high penalty rates of tax in Australia to prevent income-splitting tax dodges. You can invest in a "trust account" in the child's name and avoid these penalty rates but you are liable to pay tax on the earnings.** You can specify a vesting age when the investment bond will be transferred to the child.

My mother's will specifies that each of her grandchildren will get £25k when they are 23 y.o. My brother and I are interpreting that as investing £25k now. We set up trust accounts for his children below 23 and my son in Falafeland where he lives and my mother lived. But then on 26 June this year our second child was born. It seems I haven't mentioned this on this blog before! My brother and I agreed to also invest £25k for him.

I began to explore setting up an Australian trust for him. An Australian will can set up a "testamentary trust" in the name of a child or grandchild etc. The income on that inherited money won't be subject to the penalty rates. The twist is that the money for our newborn son is my hands now. If I just set up a trust for him I will have a battle with the ATO to claim that the penalty rates don't apply. I talked to a lawyer on the phone and she said she needs to do research on whether we can set up a testamentary trust now. This would be a lot of upfront expense and then there is the hassle of running the trust and investing on its behalf and submitting annual tax returns etc. So, I am skeptical that this is going to work and if it does it would be a lot of hassle, I think. Also a trust must pay out all its earnings every year. So our son will need a bank account to receive them and this will be an income stream that his brother won't be getting.

An investment bond seems like a simpler option and is very similar to our first child's trust account In Falafeland, which doesn't pay distributions and is taxed at 25%. The 30% tax rate seems high, but there is a trick. If you make an additional investment that is greater than 125% of the previous year's investment then the bond resets to year 1 of the 10 year period. As the previous year's additional investment could be zero this is not hard. When that happens if the child withdraws money from the bond the money is taxable at their tax rate but they get a 30% non-refundable tax offset somewhat like a franking credit. But this will only reduce your tax if currently you earned less than AUD37k per year, which is below the full time minimum wage.*** But a 23 year old might earn that little if they were doing graduate study, for example.

There are six providers according to Macquarie:

• Comminsure (Commonwealth Bank)
• AMP
• IOOF
• Australian Unity
• Centuria
• Generation Life

The first three have all been very controversial and the first two are in the process of selling their life insurance businesses to offshore firms. AMP has the lowest management fees and Australian Unity the highest of the first 4. Centuria's PDS is really not transparent. Generation Life has index fund options which would be cheaper than any of the other providers' options. Generation Life is a specialist investment bond provider. So, I am going to look at this one in more detail. I am also following up with Unisuper, whose website mentions investment bonds.

* Investment bonds don't get a long-term capital gains tax discount. So, they aren't as effective if your not in the top bracket.

** Income children earn from labor/their own entrepreneurship isn't subject to the penalty rates and neither is inherited money in a testamentary trust. Trust accounts don't work for us as the children must get the money from them at age 18.

*** It's crazy that the minimum wage is already taxed at a marginal 32.5% + Medicare Levy.

Updated Post on Labor's Tax Increase Proposals

I had forgotten about one of Labor's proposals to increase tax. Limiting tax free pensions to $75k per year. I've now added it to the list. It's number 13.

P.S.
Another one - limiting deductions ofr tax advice to $3,000 per year. Now 14 proposals on the list.

Reduced Incentive to Access Superannuation as Early as Possible

Currently, Australian superannuation earnings are taxed at 15% and 10% for capital gains while you are in the "accumulation" phase (before you retire). When you retire you can switch up to $1.6 million of assets into pension mode and then the earnings are taxed at 0%.* The downside is that then there is a minimum payout ratio every year which increases with age. Unlike the U.S., there is actually no requirement to make any withdrawals from super. But making withdrawals is incentivized by the reduction in tax rate.

But if you have shares that pay franking credits, you can use these franking credits to offset the 10-15% tax. You might not pay any net tax on your super fund in the accumulation phase. When you switch to pension mode you will get cash refunds of the franking credits.**

Labor plans to abolish these refunds of franking credits. This means that there may actually be no net change in tax due when switching from accumulation to pension mode. The incentive to switch disappears. This means that if you have assets outside super you probably should spend them first in retirement as they are relatively highly taxed. Only if you run out of such assets, should you access your super.

* Any excess remains in accumulation mode.
** You might even get some cash refunds in accumulation mode if you have enough shares paying franked dividends.

Likely Political and Economic Scenario for Australia

A couple of days ago I posted a list of all 12 of Labor's proposed tax increases. How likely is it that these will actually be enacted? Labor is unlikely to gain control of the Senate. So, they will need the support of minor parties and independents to push through their program. A quite likely scenario is that there will be a recession in 2020 and the minor parties will be very resistant to raising taxes in those conditions, especially on housing. Or Labor will decide to postpone some of the proposals in reaction to a recession. Then Labor is likely to not be re-elected in 3 years if unemployment is rising etc. So, at this point I would put even odds on most of this agenda being enacted.

All of Labor's Tax Increases

The Labor party is at the moment likely to win the next federal election in Australia in May. Labor has become increasingly left wing in recent years and has a long list of policies to raise taxes. This is, I think, a comprehensive list:

1. Abolish Liberal plan to raise the top tax threshold to $200k: This was supposed to happen in 2024. The top tax bracket will still cut in at $180k (about USD130k) where it has been for many years. Bracket creep is pushing more and more taxpayers into the top bracket. This will affect us if I am still working then. If I'm not, probably my taxable income will be lower.
   
2. Raise the top tax rate: Add 2% to the top rate to raise it to 47%. With Medicare that is 49%. This will immediately raise our taxes.
   
3. Abolish plan to eliminate 37% tax bracket: This also was supposed to happen in 2024, so may not affect us except to the extent of how many franking credits will get used up offsetting our taxes, if I retire by then.
   
4. Repeal already-legislated tax cuts for companies with turnovers of between $10 million and $50 million: Small businesses pay 27.5% corporation tax and larger companies 30%.  The government wanted to extend the low rate to larger companies. This is unlikely to directly affect us.
5. Reduce the long-term capital gains tax discount to 25%: The discount is now 50%. This will have an immediate impact on us as we have run out of accumulated tax losses. OTOH existing investments will be grandfathered. It makes it more attractive to incorporate and pay CGT of 27.5% instead of 37.5%.
   
6. Abolish refundability of franking credits: Since 2000, if you have excess tax credits from Australian companies beyond those that offset the taxes you need to pay you can get a cash refund. I did benefit from this once or twice soon after we moved to Australia and my income was low. This will have a big impact on superannuation funds in pension phase that have zero tax to pay and possibly even in accumulation phase if they have a lot of franked dividends. It will affect lower income self-funded retirees with money outside superannuation too.  Some listed investment companies (closed end funds) are already paying out special dividends to get franking credits out of the fund and to investors before the end of the financial year. On the other hand, I don't think these funds will radically restructure due to this proposal. I don't think it will have a big impact on us as I've planned to put the least tax advantaged investments like managed futures into our planned SMSF. And I expect we would be in the 32.5% tax bracket when retired. If I retire at 60 say and start a superannuation pension we could use franking credits inside our SMSF to offset Moominmama's superannuation earnings tax liability as she is 10 years younger. And then maybe we could add Moomin to the superannuation fund :)
7. Abolish negative gearing: This is the ability to deduct investment costs beyond the earnings of an investment from other income. This mainly applies to property investors who mostly lose money in Australia in the short run, hoping for a long-run capital gain. We don't negative gear so it shouldn't affect us. Wealthier property investors who also own shares or other investments will be able to offset their losses in property against dividend and other income. So, like many of the Labor measures they mainly hit lower income investors...
   
8. Tax discretionary trusts as companies: These are trusts that have multiple beneficiaries and can alter what earnings they stream to which beneficiary on a year by year basis. Actually, they are proposing to tax trust distributions at a minimum of 30%. So, it's not like a company which pays 27.5% tax in the case of a small business and then distributes franking credits. I don't see any justification for allowing this kind of tax dodging. However, I think they should just require all trusts to be unit trusts with defined shares and everyone sharing in all income. These operate just like unlisted managed funds (mutual funds). I think most discretionary trusts will just do this if it's allowed.
   
9. Reduce annual non-concessional superannuation contributions to $75k: This would mean it would take us more years to make all the non-concessional contributions we want to make and means I probably should already get one in this financial year.
   
10. Reduce the threshold for 30% superannuation contributions tax to $200k: Currently the threshold is $250k. The threshold includes employer superannuation contributions, so this will definitely affect me.
    
11. Remove the right, already legislated by the government, of superannuants to make catch-up contributions when their super balance is less than $500,000: I don't think this is probably a big deal. It will mean stretching contributions over more years.
    
12. Reduce ability to take tax deductions for additional concessional superannuation contributions: People will need to have 90% of their income or more from sources other than employment to do this. I don't understand why concessional contributions for employees are limited to salary-sacrificed contributions and you can't make more concessional contributions unless you really aren't an employee. The Liberals tried to fix this anomaly.
13. Limit tax free pensions to $75k per year: Currently you can transfer up to $1.6 million into an account to fund a tax free superannuation pension. At a 4% initial withdrawal rate (required rate for under 65s) that is $64k per year. At 5% (65-74 y.o.) it is $80k per year. So, Labor's proposal is not that restrictive. However, if the $1.6 million earns a lot more than that a year, it will be taxed a lot more than at present.
14. Limit deductions for tax advice to $3,000 per year: I am assuming that this won't apply to companies or superannuation funds, just to individuals. In which case, it isn't a big deal.

I think most people are probably aware of one or two of these but don't have a good idea of the extent of the proposed tax increases. A big question is whether Labor will have sufficient control of the Senate to pass all these measures.

Australian Federal Budget 2016

The budget released yesterday actually turned out pretty well for me despite some of the leaked stories. In the end the income level at which the 30% superannuation contributions tax start was lowered from $300,000 to $250,000 rather than $180,000 and the cap on concessional (pre-tax) contributions for people over 50 will stay at $35,000 per year. The cap for under 50s is reduced from $30k to $25k. The biggest changes are a lifetime cap on non-concessional (post-tax) contributions of $500k rather than $180k per year. I might just contribute $500k just before retiring, but it's not going to change my plans. Also there is a $1.6 million cap on how much you can transfer into a tax free account after you retire from an accumulation fund. This number seems to be designed to be equal to roughly the maximum contributions allowed under the new rules over a lifetime. Effectively earnings in retirement on earnings in the accumulation phase above the rate of inflation would be taxed....  Currently, I have $385k in Australian super. If I work to age 65 and continue my current rate of contribution I would add $450k in concessional contributions. So, I could certainly add the $500k just before retiring, as long as investment returns are not too spectacular in the interim.

Other news in the budget is that the 37% tax bracket threshold will be raised to $87k p.a. instead of $80k. That would reduced my tax by $315. So, all in all, it was an OK budget.

P.S.

Now I just read that the concessional cap has been lowered to $25k for everyone, regardless of age. So, what I read yesterday was wrong. But this is from 1 July 2017. So, in the next tax year I can keep my current contributions rate and then after that I will have to cut them and I will have a $3,000 tax hike. Of course, if Labor come to power at the election on 2 July this year that might not happen...

There are a lot of changes, which mostly make super more complicated.

Murray Report on the Australian Financial System and Superannuation

The findings of the Murray review of the Australian financial system have been released. I am most interested in their recommendations for superannuation (retirement accounts). Of course, there is no way to know yet what recommendations the government (or future governments) will take on board. This just adds to the uncertainty surrounding super. I had been thinking that now I am 50 years old, as soon as we buy a house I would start making after tax ("nonconcessionary") contributions to super. This is because once you retire there is no tax on superannuation earnings and it is only 10 years till I am 60 and could withdraw money. Though pre-tax contributions ("concessionary" - actually they are taxed at 15% instead of your marginal rate) are limited to $35k per year, you can contribute up to $150k per year after tax. But if they actually withdraw the advantageous tax status of super and worse still if they end up forcing people to take an annuity instead of being able to access their money as they like then I wouldn't want to put any extra money in super at all. The review recommends making annuities a default option, which people will have to opt out of, but I can imagine it becoming compulsory. So, for now, even when we have bought a house I wouldn't plan on adding any extra non-concessionary contributions to super. And yes I sold Qantas too soon :(

Vote Compass

The ABC have a website called Vote Compass that is meant to help in deciding who to vote for in our upcoming federal election here in Australia. I came out as a little socially liberal and right of centre economically and closest to the Liberal National Party. This wasn't a surprise at all. But it was still fun to do the survey. Snork Maiden was about as socially liberal as me but left of centre. Both of us are in the space between the Labor and Liberal parties.

I just saw that Enoughwealth has also done the survey. He came out as more socially conservative and right wing than the Liberal National Party.