Education Bonds in Australia – Sound Too Good to Be True?

Welcome back to Peasant Investor! If you’ve clicked on this post, chances are you’ve heard of Education Bonds and are wondering if they’re worth it. I recently did a deep dive for my baby and found that while these structures do have their uses, they’re definitely not for everyone (including myself)!

This post breaks down what they are, how they work and why I personally decided not to use one. I’ll keep it as factual as possible, if I’ve misunderstood anything, feel free to correct me!

What Is an Education Bond?

An Education Bond is a tax-structured investment product designed to help families save for their children’s future education expenses (that is the major kicker, but it could be withdrawn for non education purposes as well). Providers now typically offer some flexibility in terms of what investments you can hold from pre-mixed options to passive ETFs. It has some tax and withdrawal rules that can help (or hurt) depending on your situation.

The Pros of Education Bonds

1. Prepaid 30% Tax on Earnings
   If your marginal tax rate is above 30%, this could be tax-effective (but this is debatable considering with CGT discount, even at the highest marginal tax rate, we are looking at 23.5% rate)

2. Tax Rebate for Education Use
   If withdrawals are for eligible education costs (school fees, laptops, uniforms, etc), you can get that 30% tax back.

3. Useful for Estate Planning
   Bonds allow you to nominate beneficiaries and can be used in structured inheritance planning.

Principal vs Return Are Separated

This is a special feature for Education Bonds:

• Your original contribution (principal) can be withdrawn at any time, tax-free.

• The investment returns are taxed inside the bond at a flat 30% rate (this could sometimes be less depending on the investment mix, but let’s keep it simple for now).

• If you withdraw those returns for eligible education expenses, you can claim back that 30% tax as a rebate.

Sounds pretty good right? But there’s a catch — if you are withdrawing the returns portion to your child when they are under the age of 18, the benefit is rather low due to the minor tax rates in Australia. We are looking at $416 before the tax rate goes 66%! Hence, when drawing funds prior reaching 18, it makes sense to draw from the contribution bucket. This is where it gets tricky.

Here’s the Reality Check

1. Contribution Limits
   You can only contribute up to 125% of the previous year’s contributions. Exceeding this resets the 10-year tax-free clock — a rule that requires careful planning and ongoing monitoring. This is why many people use a financial adviser when deciding to invest via an Education Bond, which adds to the cost.

2. The 10 Years “Tax Free” Pitch
   While doing my own due diligence, I’ve seen a lot of pitch for this product saying that there is no tax after 10 years. What it means is that withdrawing the return portion does not trigger further tax to the individual. However, the 30% tax is already accounted for in the vehicle (although this can be rebated if withdrawing for education purposes).

3. No Capital Gains Tax Discount
   Unlike traditional investments where long term capital gains get a 50% tax discount (for individuals), Education Bonds don’t qualify. If you don’t get to claim back the 30% rebate on all the investment returns, you may end up paying more tax than you would otherwise.

4. High Fees
   Most Education Bonds charge around 0.7% annually, on top of the investment option’s own management fees. Over time, these fees eat into your compounding.

5. Minor’s Tax Rules Apply
   If the return is assigned to a minor, keep in mind that kids under 18 only have a $416 tax-free threshold. That limits how effective the rebate can be in the early years. 

Why I Decided Against It

I played around on Excel to see how Education Bonds stack up against just investing under my wife’s name (who is in a tax bracket below 30% plus can enjoy CGT discount). Here’s why we decided not to use one:

• My wife’s lower tax rate makes regular investing more flexible and potentially more tax effective.

• Higher costs via Education Bond mean slower compounding over time. In a 10 year horizon, that is looking at 7%!

• Even with strategic withdrawals (e.g. drawing down principal during Years 7–12 where costs are typically higher and saving the returns portion for university), the actual tax rebate benefit is ~$5,400 per year (30% of $18,200). This assumes that the child does not have any other income sources as well. 

• Losing the flexibility of investing how much and when you want, remember drawing the returns portion earlier than 10 years has other tax complications.

Finally, do your maths, understand the rules and don’t just chase the hype!