Case Study - Insurance Bonds - Planning for Education Expenses
Insurance bonds can be a useful way of saving for large education or other expenses. They are taxed within the bond at 30% so do not impact on the investor’s personal tax. If held for a minimum of ten years, withdrawals are tax free to the investor. If withdrawn before 10 years, withdrawals are taxed at the marginal tax rate less a rebate of 30% for tax already paid within the bond (concessional rules apply between 8 and 10 years). After the initial deposit is made, the investor can deposit each year up to 125% of the previous year’s deposit without nullifying the tax timing status.
Ray and Kathy have two young children and want to plan to have enough funds set aside for their expected large education expenses once the children move to secondary school and thence university. The expected profile for the expenses is shown in Figure 1, both in constant (today’s dollars) and in nominal dollars after applying inflation. Obviously, these values include a fair amount of uncertainty so ideally the plan may need adjusting as times goes on. Note that an Insurance bond allows for deposit flexibility within the 125% rule. They also have the option of meeting any funding shortfall from current income.
- Insurance bonds can be a useful way of saving for future large investments, particularly if the persons involved have a marginal tax rate greater than 30%.
- Pathfinder enables you to map out a savings plan over time.
- Pathfinder automatically provides guidance on concessional and non-concessional super contributions.
- Pathfinder also alerts you to schemes such as spouse super contribution, co-contribution and use of unused concessional super caps.
Ray and Kathy have decided to save for these expenses using an Insurance bond so that the money is at “arms length”. They want to know how to structure their deposits over time so that they can meet their goal and also fit in with their other expenditure and savings.
The education expenses are fairly modest while the children are in primary school and Ray and Kathy feel comfortable about meeting those expenses out of current income. As seen in Figure 1, expenses start to become more onerous in 2025/26 when the first child starts secondary school. Ideally, they would like to draw from the Insurance bond at that point but recognise the withdrawals only become tax free in 2027/28. Nonetheless, by holding the Insurance bond in Kathy’s name they could plan to meet expenses from the Insurance bond from 2025/26. Kathy is expected to be on a marginal tax rate of 21% at that time but she receives a rebate of 30% for tax already paid in the bond. However, in this analysis we will assume that Ray and Kathy don’t draw on the bond before 10 years.
We have assumed in the analysis:
- Insurance bond returns 4.9% pa (after tax);
- CPI 2.5% pa;
- AWOTE 3% pa;
- Ray has a salary of $110,000 pa indexed at AWOTE;
- Kathy is currently working part-time on a salary of $23,000 pa indexed at AWOTE, but may consider resuming full-time work at a later date;
- Base annual living expense $65,000 indexed at CPI.
Pathfinder is an excellent tool for helping Ray and Kathy plan. We have setup the problem in Pathfinder and specified that savings must start in 2017/18 and be complete by 2026/27. Withdrawals from the Insurance bond must meet all anticipated education expenses from 2027/28 onwards.
The strategy as developed by Pathfinder has Ray and Kathy purchasing an Insurance bond with an initial deposit of $13,500 in 2017/18. For the following 9 years they contribute additional amounts of between $17,000 and $22,000 each year with the bond reaching an expected value of $233,000 in 2027/28. This plan is illustrated in Figures 2 and 3.
Ray and Kathy commence paying school fees of $2,100 pa in 2019/20 from current income. The fees are below $5,000 pa until 2025/26 so are manageable from current income. They increase to $14,600 in 2025/26. The fees in 2025/26 and 2026/27 are also paid from current income although other approaches could be adopted such as:
- Have additional savings outside the Insurance bond;
- Withdraw relevant amounts from the Insurance bond with some tax being payable.
From 2027/28 onwards, withdrawals are made from the Insurance bond to match the education expenses. No tax is payable on these withdrawals as the bond has been held for 10 years.
In this example, an Insurance bond has been used to meet expected large education expenses for future years. Such bonds are particularly effective if the marginal tax rates of the parents are above 30%. But in any case, by setting aside a special pot of money the parents can have comfort that the children’s education won’t suffer if the parents are unable to meet the large annual amounts required from current income.
A similar strategy might be used for other large expenses, for example planning for the children’s wedding.
Optimo Pathfinder can be a useful tool for helping plan such strategies in conjunction with other goals people might have.
Finally, although we do not report here but Pathfinder will automatically provide guidance on such things as:
- Maximising concessional and non-concessional super contributions;
- Making a spouse super contribution to obtain a tax rebate;
- Making a non-concessional super contribution to get the Government co-contribution;
- Using the unused concessional cap provision to accelerate super once other large expenses are behind.
For more information and how Optimo Financial can assist you, contact us.