Locked out of the super system? Tax-paid savings bonds could be the answer

If you’re locked out of the super system due to your age or some other reason, have we got a deal for you! It looks like a super fund, behaves like a super fund, but it isn’t a super fund.

We’re talking about tax-paid savings bonds. Not to be confused with the fixed-income securities issued by governments and corporations alike, these are tax-paid investments that date back to Australia’s original 1936 Income Tax Act.

Like a super fund, you can squirrel money away and, if left in place, you avoid having to include the investment earnings in your personal income tax returns. In fact, in some cases, you might not need to lodge a tax return! And just like a super fund, play by the rules and you’ll end up collecting the proceeds completely tax free.

Years ago, this unique income tax structure formed the basis of most traditional life-insurance policies. They then morphed into savings plans, which were sold by insurance agents through the 1970s an ’80s. Heavy fees and commissions in the past meant that returns were “ordinary” at best. Fees were as much as 3 per cent of the total account balance each year.

But now, savings bonds are on offer for about 1.3 per cent, depending on the underlying investment mix. On par with a typical employer super fund, this is a stripped-back investment fee with no nasty adviser fees or commissions. These are now banned from being bundled within the management fee charged by the fund.

Like super, they are a tax-paid investment. In essence, we hand our money over to a fund manager to invest on our behalf. They deal with the tax and reporting issues and provide access to the funds as required. Like super, we select the investment mix and can opt for a growth-type fund with a high exposure to riskier assets such as shares and property or a conservative mix with a higher allocation to safer options. Needless to say, the safer approach will produce a lower return and is usually cheaper.

The fund pays tax at the rate of 30 per cent on the earnings of the fund. Provided you leave the fund in place for 10 years, any withdrawals will be received tax free. If you access the money within eight years of setting up the fund, the part of the withdrawal that represents the growth is taxable, but comes with a 30 per cent tax credit. If you dip into the fund in year nine, two-thirds of the growth is taxable, and in year 10, one-third.

Tax at 30 per cent means that for low or nil taxpayers, the use of savings bonds needs to be weighed up against other ways of saving tax, but that argument can be applied to any strategy.

Savings bonds suit high-income earners and, surprisingly, investments held in a child’s name. That’s because kids cop a penalty tax that equates to the top marginal rate of 45 per cent on earnings. Set one of these up in junior’s name and after 10 years, no tax.

Like the contribution cap rules on super, there are some restrictions on how you pump your spare dollars into these funds. To stop people dumping a pile of cash into the scheme in year eight to receive the proceeds tax-free two years later, you can only put in 125 per cent of the previous year’s contribution.

Let’s say you start with $10,000. In year two, you could put in $12,500. But if you only put in $2,000 the following year, you would be restricted to putting in $2,500 maximum in year four. If you put in more than the 125 per cent, the 10-year clock is reset. The sensible thing to do would be to start another fund.

There’s other spin-off benefits to tax-paid savings bonds that shouldn’t be ignored:

1. You can nominate beneficiaries, which in essence bypass the complex world of wills and estate distribution.
2. If the bond owner dies, the proceeds can be distributed tax free, irrespective of how many years the fund has been in place.
3. There’s reasonably good protection from bankruptcy as well. Investments covered under life-insurance laws, including bonds, doesn’t normally form part of a bankrupt’s estate.
4. And finally, because there’s no investment income to declare on your tax return, it may open you up to receive concessions that might be income tested. That includes a senior whose income is too high to receive a Commonwealth Seniors Health Card, providing big discounts on medicines and utilities.

Want to know more? Read our other money articles here.

IMPORTANT LEGAL INFO This article is of a general nature and FYI only, because it doesn’t take into account your financial or legal situation, objectives or needs. That means it’s not financial product or legal advice and shouldn’t be relied upon as if it is. Before making a financial or legal decision, you should work out if the info is appropriate for your situation and get independent, licensed financial services or legal advice.