With the tax burden on individuals set to rise from the start of the new financial year in April, companies in the finance sector are gearing up their efforts to promote financial products that can help mitigate the impact.

Graeme Clark, Courtiers Head of Private Clients, recently said he was increasingly aware of attempts by companies to promote a specific type of product that does just that. This product is called an investment bond and over the coming months, you may well see an increasing number of adverts for them.

This article is an introduction to investment bonds, focusing on the main features and some of the potential ways they can be used.

It’s important to be aware that investment bonds are sophisticated and complex products and may not be suitable for everyone. Before investing in them, changing them or selling part or all of them, please contact your Financial Adviser.

Investment bonds explained

An investment bond is a whole of life insurance policy, which means it doesn’t expire at the end of an agreed period. They’re issued by life insurance companies and typically used as an investment vehicle to take income and for capital growth. Among their most appealing features is that they provide tax planning opportunities.

Investment bonds give investors access to a wide range of assets including collective funds, cash, and government and corporate bonds. Generally, they provide minimal elements of life assurance. Some bonds are made up of a single policy, whereas others comprise several different policies or segments. The value of investment bonds can go up or down and you may not get back what you originally invested. There are two types of investment bonds – onshore; those located in the UK, and offshore; those located in jurisdictions, such as the Republic of Ireland and the Channel Islands.

Courtiers Funds

Some issuers of investment bonds allow a third-party discretionary fund manager to be appointed. Where this is the case, policy holders can appoint Courtiers to be the discretionary fund manager for the funds held within the bond.

The administration of the investment bond (adding to it or making withdrawals) is the responsibility of the life company that provides the bond.

Investments bonds – Main features

Deferring income tax

Investment bonds are subject to Income Tax not Capital Gains Tax (CGT).

One of the main attractions of investment bonds is that they allow tax on withdrawals of income from an investment bond to be deferred. Note, this does not mean such withdrawals are tax free.

Each year a bond holder can withdraw up to 5% of the original amount invested (the year begins on the date that the investment bond starts) without incurring a tax charge. This could be used to provide a regular income. The 5% includes Adviser charges. If you withdraw 5% a year, you will have used up your allowance after 20 years. If you withdraw 4% a year, the allowance will be used up after 25 years.

This can be particularly beneficial when the bond owner is currently in the higher or additional rate income tax bracket but expects to be in a lower rate tax band when tax is eventually due sometime in the future – after they’ve retired, for example.

As long as withdrawals are within the 5% annual allowance, any income or capital growth does not need to be included in a tax return.

If you don’t use the allowance in one year you can carry it forward to the next year. For example, if you invest £200,000 in an investment bond but don’t make any withdrawals in the first four years, you can withdraw £50,000 (4 x £10,000 for years one to four + £10,000 for year five) in the fifth year without an immediate tax charge.

Uses and abuses

An important feature is the ability to assign (gift) all or part of an investment bond to someone else. As long as the gifting is genuine and does not lead to cash changing hands (i.e. the new owner encashes the bond and gives it back to original policy holder), this is not classed as a chargeable event for the purposes of income tax, and no tax is due at that point. More on chargeable gains below.

Although the new owner may subsequently be liable for tax on any chargeable gain, the tax due will be at their marginal rate. This makes gifting to non-taxpayers or those on lower tax rates especially beneficial from a tax planning perspective.

Where there’s a will

An investment bond can be a useful way of passing on wealth. If you have a will, it can be passed on to your named beneficiaries. Without a will it passes to the next of kin as part of your estate.

If you survive for seven years, investment bonds gifted or assigned to designated beneficiaries are considered to fall outside your estate for Inheritance Tax (IHT) purposes.

In bonds we trust

Investment bonds can be put into trust providing further tax planning opportunities. Where this is the case, trustees have the ability to assign ownership from themselves to a beneficiary. If the beneficiary is a lower rate taxpayer or has unused tax allowances, this could result in a favourable tax outcome.

Depending on the type of trust and whether any settlors are alive, and if not when they died, there can be tax implications for settlors and trustees.

Making allowances

Investment bonds can also be useful for people who’ve already used up their annual CGT allowance. In this respect, the halving of the allowance from £12,300 to £6,000 from the start of the 2023/24 tax year only enhances their attractiveness. The freezing of other reliefs and allowances, e.g. ISAs is likely to have a similar effect.

As a life insurance policy, investment bonds are not normally included when local authorities calculate how much you’ll pay towards care costs. However, where the local authority believes that a motive for investing in investment bonds is to avoid care costs, you could fall foul of the rules on the deliberate deprivation of assets in which case the bond could be treated as a capital asset.

Chargeable events

An investment bond is a non-income producing asset, which means that income tax is only chargeable when what’s called ‘a chargeable event’ results in a chargeable gain.

It’s important to note that not all chargeable events result in a tax charge, as this depends on the bond holder’s individual circumstances.

So, what are the chargeable events that could lead to income tax being due?

If you withdraw more than 5% in any year, the amount over this allowance is a chargeable gain and may be taxable.

Investment bonds are typically taken out as long-term investments, which means that even after annual withdrawals of 5%, investors can reasonably expect the value to rise, ultimately resulting in a chargeable event.

Other chargeable events when income tax may be due are;

• when the bond is surrendered fully
• the death of the last assured
• If you pass the bond in trust in your will, this can sometimes also be a chargeable event and tax may be due. However, it depends on the bond itself and the life or lives insured.
• Time apportionment relief allows the chargeable gain to be reduced based on how long the policy holder has lived outside the UK. On 6 April 2013, this was extended to cover new policies issued by UK insurers on or after that date. Previously, it had only been available for polices issued outside the UK. This relief makes investment bonds particularly attractive for people who leave the UK and go abroad to live.

Working out the chargeable gain in each of the above scenarios is beyond the scope of this article. Please contact your Financial Adviser for assistance with such queries. However, the basic rule is that when the bond is surrendered any withdrawals are added to the original value of the bond.

Taxing investment bonds – An example

Mrs Wright purchased an investment bond for £40,000. She took annual withdrawals of 5% for seven years. There was no tax due on the income she received at the time she made the withdrawals. When the policy ended the bond’s value had grown to £65,000. The chargeable gain is £39,000. This is calculated as follows; £65,000-£40,000+£14,000 (the total withdrawn).

Two types of investment bond

There are two types of investment bonds: onshore and offshore, each with their own rules on how they are taxed.

For onshore bonds, the general rule is that no basic rate income tax is due because an equivalent amount is paid within the fund by the life company. However, if you’re already a higher rate taxpayer then any gain accruing from the bond that takes you above the higher rate threshold will be charged an additional 20% income tax. Or an extra 25% if you’re an additional rate (45%) taxpayer.

With offshore bonds, investments within an offshore bond are not subject to annual CGT or income tax, so gains can ‘roll up’ tax-free potentially for many years. Unlike onshore bonds no tax credit is given for tax already paid. When tax is due on any chargeable gains, this will be at the policy holder’s marginal rate. However, as investment gains from bonds are classed as savings, policy holders can make use of any available annual savings allowance, (£1,000 for a basic rate taxpayer, £500 for a higher or additional rate taxpayer).

Top slicing relief

Although the ability to defer taxation potentially for many years is one of investment bonds’ biggest selling points, the downside is that when you come to cash a bond in or when another chargeable event occurs, the accrued investment returns, which at that point would ordinarily become taxable in a single tax year, can push policy holders into the higher or additional rate tax brackets.

One way to potentially avoid this is to apply what’s called ‘top slicing relief’, which spreads the tax liability, typically over a number of years. Top slicing relief can be complicated and is best done with the help of a Financial Adviser.

Conclusion

Investment bonds can be a tax-efficient way to gift or pass on wealth, particularly when the recipient is in a lower income tax bracket than the person gifting the bond.

Investment bonds can also be a good way to defer paying income tax. But importantly they are not tax free and depending on individual circumstances, significant amounts of tax may be due, albeit in the future.

Not surrendering (encashing) part or all of an investment bond until you are in a lower income tax bracket, can also reduce your tax bill.

Investment bonds can also be put into a trust, providing further tax planning opportunities.

Depending on the return of the underlying investments, the value of an investment can go up, although this is of course not guaranteed.

It’s important to note that investment bonds are complex and can incur high charges, including charges for cashing in your bond early.

Investment bonds are best considered as part of a holistic approach to your finances and wealth management. Might it be better to invest available money into a stocks and shares ISA or a pension? Both of these can also be tax efficient albeit in different ways.

Your Financial Adviser will be able to answer these types of questions and help you decide whether investment bonds are appropriate to meet your needs and objectives.