Investment Bonds Part 1: How They Work, Tax Deferral, and Using Bonds for Retirement Planning
Deferring Tax to a More Favourable Point in Time
Investment bonds are becoming an increasingly popular tool in our financial planning toolkit. As various tax-free and contribution allowances are squeezed and taxes increase, the tax deferral option offered by investment bonds is increasingly attractive.
The capital gains tax annual exempt amount has plummeted from £12,300 to just £3,000 in recent years. From April this year, income tax on dividend income is set to rise by a further 2% for basic and higher rate taxpayers. And high earners now face tapered pension annual allowances as low as £10,000 per year, a fraction of the standard £60,000 allowance.
For those with surplus savings, beyond their pension and ISA capacity, investment bonds may be worth considering.
But they are complicated. To break them down, we’re planning a three-part series looking at the three major use cases of bonds: retirement planning, school fee funding, and trust planning.
We’ll spread these out over the coming weeks as we also recognise that they’re not for everyone, and investment bond technicalities can make for rather dry reading if taken in one go.
This week, we’ll focus on the basics of how investment bonds work and their application in retirement planning.
Please note, 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 where investing for a short timeframe (we usually recommend a horizon of at least 5 years). Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
What are investment bonds?
We’ll start with what they’re not: investment bonds are not bonds in the traditional sense - they’re not IOUs issued by governments or corporations.
Rather, they’re tax-efficient investment wrappers, much like ISAs and pensions: essentially a place to hold underlying investments.
These products are issued by life insurance companies and contain a tiny amount of life cover – normally 0.1% or 0.01% of the investment value. This nominal life insurance element enables them to qualify for certain tax advantages, most notably the deferral of taxation on profits and the ability to assign sub-policies or ‘segments’ to others (more on both of these aspects later).
This can sound almost too good to be true from a tax planning perspective, but investment bonds are well‑established products and have been used for decades.
They’re issued by mainstream, well‑known insurance providers. In the onshore market, the most widely used providers include Prudential, Quilter and Aviva, while the offshore bond market is dominated by Canada Life, Utmost Wealth and Transact.
How do they work and how are they taxed?
The mechanics are admittedly complex, but the worked example at the end of this section should help bring things to life.
The basics
You invest a lump sum into either an onshore or offshore bond. Onshore means UK-based; offshore typically means Isle of Man or Ireland.
Your money is then invested in an underlying portfolio. Most bonds offer ‘open architecture’, meaning you can hold any mainstream fund inside, e.g. BlackRock, Vanguard, Dimensional, Fidelity and so forth. Direct stocks, however, aren’t permitted.
The bond is usually split into multiple sub-policies, known as segments - typically 1,000 with our preferred provider. This segmentation creates valuable tax planning opportunities, as it allows you to surrender (cash in) or assign individual segments, helping to manage and control any tax liability more effectively.
Tax treatment whilst invested
Offshore bond profits roll up without any immediate tax to pay. Onshore bonds, by contrast, incur corporation tax inside the bond structure, and profits are later deemed to have a non-refundable basic rate tax credit.
The 5% withdrawal allowance
Each year you can withdraw up to 5% of the initial premium (the amount you invested) without triggering an immediate tax charge. Any unused allowance rolls forward to subsequent tax years.
However it’s crucial to note that these withdrawals are not tax-free (a common misconception). There’s no immediate tax to pay, but taxation is merely deferred to the point of encashment/surrender.
Chargeable events
Later, when you surrender (encash) the bond or segments thereof, this triggers a ‘chargeable event’ and tax becomes due. The profit is calculated as the bond value plus withdrawals to date, less the initial investment (and less any previous chargeable gains if you’ve exceeded your withdrawal allowance, though this is rare with proper planning).
Profits from investment bonds are taxed as savings income, meaning they’re subject to income tax at 20% (basic rate), 40% (higher rate), or 45% (additional rate). However, ‘top-slicing relief’ can help reduce the tax bill. This effectively divides the total gain by the number of complete years the bond has been held, helping to determine how much, if any, of the gain falls into the higher or additional rate bands.
Assignment
Bonds allow you to assign segments to others without cost, shifting the point of taxation onto them, potentially someone in a lower tax bracket.
The key advantage
Ultimately, the play here is tax deferral. Investment bonds allow you to defer tax to a more favourable point in time (e.g. to bridge the gap between retirement and commencement of State Pensions) and/or assign segments to a taxpayer with more favourable tax status.
Three major use cases
In our view, investment bonds have three major use cases:
Retirement planning
School fee funding
Trust planning
In this week’s blog, we’ll focus on the first - retirement planning. And we focus on offshore bonds over onshore as these typically offer the greatest flexibility, with scope to draw some bond profits without any tax to pay.
Worked example: Retirement planning
Background
Sarah is 52 and a higher-rate taxpayer earning £150,000 a year. She recently received a £500,000 inheritance.
She has already maximised her annual pension contributions and ISA allowances, and also holds a substantial General Investment Account (GIA). Ordinarily, we would prioritise using available tax wrappers such as ISAs and pensions before considering an investment bond, but in Sarah’s case, these options have already been exhausted.
Sarah does not anticipate needing access to these funds for at least 10 years but values flexibility in planning for her retirement.
Sarah chooses to invest the £500,000 into an offshore investment bond, structured into 1,000 segments of £500 each.
Year 1-5: The accumulation phase
Sarah takes no withdrawals during this period.
Assuming a 6% annual return (illustrative), the bond grows to approximately £670,000.
As this is an offshore bond, there is no immediate tax on investment growth – no income tax or capital gains tax. This so-called ‘gross roll-up’ allows full compounding of returns with no tax drag.
Additionally, as no taxable income or gains are generated, there is no requirement to report the bond on Sarah’s tax return.
These figures are for illustrative purposes only and do not reflect actual investment returns, which can fluctuate and are not guaranteed.
Year 6: Ad Hoc Withdrawal
Sarah decides to renovate her home at a cost of £75,000.
As she remains an additional-rate taxpayer, she opts to make use of the bond’s 5% tax-deferred withdrawal allowance. This allows her to withdraw up to 5% of the original investment (i.e. £25,000 per year), with any unused allowance carried forward.
She hasn’t made any withdrawals to date, so she can draw up to £150,000 tax-deferred (6 years x £25,000).
She only needs £75,000, which she draws without triggering any immediate tax liability.
However, these withdrawals will be factored into the gain calculation if she later surrenders any segments.
Year 6-10: Continued Growth
No further withdrawals are made.
Assuming a continued 6% annual return, the bond grows to around £760,000 by year 10.
Year 11: Retirement at Age 62
Sarah retires and now requires £4,000 per month to fund her lifestyle.
At this point:
She has no other earnings, but she does receive approx. £10,000 a year in investment income (dividends and interest) from her GIA and cash savings - currently reinvested.
Her bond is worth £760,000, with £75,000 in tax-deferred withdrawals already taken.
Rather than making another tax-deferred withdrawal, Sarah now starts surrendering individual segments to take advantage of her full tax allowances and lower income.
Segment Surrender Strategy
If Sarah were to surrender the entire bond:
Current value: £760,000
Plus tax-deferred withdrawals: £75,000
Less original investment: £500,000
Equals chargeable gain: £335,000
The entire gain would be taxed as savings income, clearly not optimal as this would result in a substantial tax charge.
Instead, she surrenders 65 of the 1,000 segments, equivalent to:
£760 each (£760,000 ÷ 1,000)
With an individual gain of £335 per segment (£335,000 ÷ 1,000)
Total chargeable gain on surrender: 65 x £335 = £21,775
Assuming her other taxable income equates to £10,000, of the £21,775 chargeable gain, £8,570 is tax-free, covered by her remaining Personal Allowance (£2,570), Personal Savings Allowance (£1,000) and 0% Starting Rate Band for Savings Income (£5,000).
The remaining £13,205 is taxed at 20% (basic rate) = £2,641
That is, Sarah will receive gross proceeds of £49,400 (65 segments x £760 value). She’ll need to set aside £2,641 for income tax, implying net proceeds of £46,759.
The tax charge of £2,641 in this example, implies an effective tax rate of just 12% (£2,641 tax ÷ £21,775 gain), though this will of course depend on other sources of taxable income.
Regarding the balance, the remaining 935 bond segments continue to grow within the bond. She can repeat this process annually, optimising tax efficiency year-on-year.
Summary
Investment bonds can be a powerful tool for retirement planning, particularly for those who have already made full use of their pension and ISA allowances and are looking for further tax-efficient investment options.
They offer the ability to defer tax until a more favourable point in time and provide added flexibility through features like the 5% tax-deferred withdrawal allowance and segment surrender strategies.
In the right circumstances, bonds can deliver material tax savings - especially for individuals transitioning from work into retirement, with an anticipated gap in income before the commencement of State and private pensions in later years.
However, they are not without drawbacks. The primary downside is complexity. Bonds are not as intuitive as ISAs or pensions and come with a unique tax regime that requires careful planning and advice. They may also be slightly more expensive than other wrappers, although this gap has narrowed significantly in recent years.
Happy Thursday!
Kind regards,
George
George Taylor, CFA
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This blog is for general information only and is intended for retail clients. It does not constitute financial or tax advice, nor is it an offer to buy or sell any specific investment. Since I don’t know your personal financial situation, you should not rely on this content as tailored advice. While we aim to provide accurate and up-to-date information, we cannot guarantee that all details remain correct over time. We are not responsible for any losses resulting from actions taken based on this blog’s content.
