The name’s Bond – Investment bond!

Investment bonds are a tax-efficient way to hold investments, similar to other ‘wrappers’ (individual savings accounts, pensions, etc). With increasing capital gains tax (CGT) rates, they are worth considering – particularly for higher earners planning for retirement.

Investment bonds are established with an insurance company and funded with a lump sum or regular cash contributions. The contributions are usually invested into funds (unit trusts, exchange-traded funds, etc.), which can be accessed at any time through full or partial surrenders.

Investors can choose a UK or offshore bond. UK bonds pay 20% tax on their profits, but the investor receives a 20% credit for this underlying tax when they surrender the bond. Offshore bonds (which are the typical choice) pay no tax, so profits ‘roll up’ tax-free. There is no tax on investment income or changing from one fund to another.

The investor can withdraw up to 5% of the original amount invested each tax year without any immediate personal tax, with any unused allowance carried forward to the next year.

What’s the catch?

So far so good – tax-free roll-up, no tax return reporting, and 5% can be withdrawn each year. Sounds too good to be true?

Here’s the downside: all profits (whether triggered by exceeding the 5% limit or surrendering the bond) trigger a ‘chargeable event gain’ which is taxed as income at your highest rate (not CGT, even if the profits are from capital growth).

This sounds like a drawback; but deferral could allow you to delay the tax charge until you are a 20% taxpayer, which is now lower than the 24% higher CGT rate.

Slice of the action

Realising a large chargeable event gain in one tax year could push you into higher tax rates. Recognising this unfairness, ‘top slicing relief’ (TSR) allows you to split the gain into annual ‘slices’ to reduce the impact of higher rates.

Suppose that an individual earns £40,000 and triggers a £25,000 gain on a bond held for five years. Some of the gain would be taxed at 40%, but one annual ‘slice’ of £5,000 would be taxed at 20%. TSR allows the entire gain to qualify for 20% tax (which would be offset by the 20% credit, if it was a UK bond) to alleviate the spike in income.

Example: Planning for the exit

Ross, 55, sells his business but continues working, earning £130,000 per annum. He puts £1m cash into an offshore bond to roll up tax-free. He withdraws £50,000 each year with no immediate tax, and no reporting on his tax return. At 60, he stops work and surrenders half the bond, realising a £100,000 gain. Now, as a basic-rate taxpayer and using TSR, he pays only 20% tax on the gain. He has deferred tax for five years and reduced the overall rate from 45% to 20%.

Inheritance tax planning

Another advantage of investment bonds is that a gift does not trigger a chargeable event. This is only triggered when the recipient eventually partially or fully surrenders the bond. Continuing the example above, Ross could gift the remaining portion of the bond to his grandchildren, starting the seven-year clock for inheritance tax purposes, and allowing future profits to be taxed on his grandchildren at potentially lower tax rates.

A sting in the tail?

There are a couple of downsides:

There is no tax-free uplift on death like CGT; all unrealised profits are taxable.

Exceeding the 5% annual allowance can trigger tax even without a profit – see Lobler v HMRC [2015] UKUT 152 (TCC), where a partial surrender nearly led to £500,000 tax on a £50,000 gain! Bonds can be set up in segments to manage this problem.

Practical tip

If you’re a 40% or 45% taxpayer and have used your ISA and pension allowances, consider investment bonds. But make sure to gift the bond before you die! As always, seek independent
financial advice.

Disclaimer: The information provided on AccountingFirms.co.uk is for general informational purposes only and should not be considered professional accounting, tax, or legal advice. Always consult a qualified accountant or tax adviser for advice tailored to your individual circumstances.