Deferring tax on investment profits from higher rates to basic/non
In this latest blog, I cover investment bonds – what are they, why might you consider one, and how do they work?
Also, how they could be pushed up the agenda, were a new government to increase capital gains tax rates (as has been mooted in the press).
What are they?
Firstly, what are they not? They’re not bonds in the traditional sense - ‘IOUs’ issued by governments and corporates, providing you with a pre-specified return over a pre-specified period.
Rather, they are investment products issued by life insurance companies.
They typically carry a token amount of life insurance (e.g. 0.1% of the value). As a result, they qualify for considerable tax benefits, most notably that there is virtually no immediate tax to pay on underlying investment profits until the point of encashment – more on these later.
That might sound like some sort of tax planning wizardry (hence the AI-generated image above), but investment bonds have been around for a long time and are widely used across the UK investment market.
There are two types of investment bonds – onshore and offshore. The tax treatment differs slightly – I’m going to focus on offshore bonds which are generally more effective (in my view).
How do they work?
An offshore bond is funded with an initial lump-sum deposit, aka. a premium.
The monies can then be reinvested in the same sort of funds that you would hold via a normal stocks & shares ISA, pension or investment account. However, you generally cannot hold single stocks within the bond.
The main draw of an investment bond is in the subsequent tax treatment:
- There is virtually no immediate tax to pay on underlying investment profits (income or gains) within the bond,
- Tax is instead deferred until you come to encash the bond at a later stage,
- When you do come to encash the bond, all investment profits, whether they originated from income or capital gains, shall be taxed as savings income, i.e. at 20% for a basic-rate taxpayer, 40% higher and 45% additional,
- The bond will be subdivided into hundreds, even thousands of underlying sub-policies, known as ‘segments’. This creates excellent tax planning opportunities, e.g. encashing just enough segments to keep the resultant bond profits within your basic-rate tax band or, better still, within your tax-free allowances,
- You’re also able to assign (or appoint in the case of a minor) segments to another individual, or into trust. There is no tax or charge on the assignment (as long as this is not done for money or money’s worth), and this has the effect of moving the point of taxation onto the assignee. This can be a highly effective way of gifting funds to a child or grandchild and capitalise on a period of low/zero earnings, during university say,
- You can withdraw up to 5% of the initial investment each year, which rolls into the next one if unused, without any immediate tax charge – again, this is deferred until a future encashment.
The worked example below should ‘bring the above to life’.
Why invest via an offshore bond?
The key benefit is tax deferral, shifting tax on investment profits from a period as a higher or additional rate taxpayer to one as a basic rate or even non-taxpayer.
Consider the following example:
Jack and Kate are 45 years old and both earning extremely well, c. £400k each.
They’ve maxed out their ISAs, maxed out their pensions, paid down a significant chunk of their mortgage and have a modest investment account, enabling them to use their capital gains tax allowances each year (now just £3,000 each).
They’re currently sitting on surplus cash of c. £500k and seek advice on ‘what to do with it’.
On my recommendation, they open a new offshore bond and fund this with an initial deposit (aka. premium) of £500k. The monies are then reinvested in a globally diverse, factor-focused, single multi-asset fund (my preferred approach).
One year later…
- Assume the bond is worth £530k at the end of the first year (a 6% return after costs),
- Jack and Kate have no need for any additional funds at this point, in which case the monies remain invested within the bond,
- As such, there is no immediate tax to pay on the £30k investment profits – this simply ‘compounds’ into the next period (see last week’s blog for a recap of the power of compounding),
- With no income or chargeable gain, there’s also no need to declare the bond profits on their tax return.
Ten years later…
- The bond is now worth say £895k and Jack and Kate plan to retire. They require around £10k a month to fund their immediate spending needs,
- They have no other income and therefore have the following tax-free allowances available – a £12,570 Personal Allowance, £1,000 Personal Savings Allowance, and a £5,000 Starting Rate Band for Savings Income (a combined £18,570), which can all be set against any realised profits (aka. ‘chargeable gains’) from the bond, as these are classed as savings income.
- The bond is split into 1,000 segments, each worth £895 and with unrealised profits to date of £395,
- If the objective were to pay zero tax on exit from the bond, they could surrender 47 segments each,
- That would result in a chargeable gain of £18,565 (47 segments x £395 profit per segment), which now becomes liable to income tax – this is the key point with investment bonds, that tax falls due on policy surrender.
- However, the gain falls just within their tax-free allowances, hence no tax is due and they would receive net proceeds of £42,065 each (47 x £895). This could then be repeated in the next tax year and beyond until the bond monies are exhausted.
- This would be the ‘perfect bond exit’ – no tax during the lifetime of the bond and no tax on exit, but this will be dependent on their wider circumstances – i.e. other income. In this example, the combined bond surrender proceeds of £84k would fall short of their income requirement (£120k) – they would therefore need to top this up from some other source, e.g. cash or investments, and/or surrender additional bond segments and incur basic rate tax (20%) on these – still fairly tax efficient.
Assignment to children…
- The other key benefit of investment bonds is the ability to assign sub-policies to another individual (or into trust), without charge.
- Continuing the example above, assume that ten years on, Jack and Kate have a daughter who has just turned 22 and is in her final year of university, with no taxable income,
- They could also assign 47 segments to her, which could then be immediately surrendered to use the daughter’s tax-free allowances. The proceeds (£42k) could then be put towards say a house purchase or some other need.
As you can see, investment bonds offer considerable tax planning opportunities.
Disclaimer: When investing, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invested, particularly when investing for a short timeframe (we normally recommend a horizon of at least 5 years). Neither simulated nor actual past performance is a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances. These figures are for illustrative purposes only and do not reflect actual investment returns, which can fluctuate and are not guaranteed. The Financial Conduct Authority does not regulate tax advice. Offshore bonds are not covered by the Financial Services Compensation Scheme ‘FSCS’.
What’s the catch?
In terms of the drawbacks of investment bonds:
- They’re quite ‘clunky’, requiring a fair amount of paperwork and wet signatures (!!),
- Product charges are slightly higher than a standard investment account – on a £500k investment, you’d be looking at a c. 1.0% set-up fee, then c. 0.25% ongoing – investment and advice fees shall be charged in addition to this,
- Most significantly, all investment profits, whether these originated from dividend income, interest income or capital gains, shall be taxed as saving income on eventual encashment. This means you cannot set the profits against available Dividend or Capital Gains Tax Allowances, or benefit from the 10% basic rate on capital gains over the tax-free allowance.
Expanding on the final point, for basic-rate taxpayers, investment accounts are generally a better option, due to the favourable capital gains tax ‘CGT’ regime.
However, should this change, e.g. if CGT rates were to be aligned with income tax – as has been rumoured previously – this would increase the relative appeal of investment bonds.
One to watch…
Disclaimer: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. Since I don’t know your specific situation, none of this information should be construed as tax or financial advice. It is not an offer to purchase or sell any particular asset and it does not contain all the information which an investor may require to make an investment decision. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of any articles.
