Investment bonds or single premium whole of life insurance policies as they are more formally known are unique investments that are taxed in a unique way. Due to their unusual nature, the ways to mitigate taxation on their encashment are different too. So why should this bother you? It’s because bond taxation can be quite complex and it can be very expensive if, when surrendering such a policy, it is not done in the most tax-efficient way. Let me explain.
There are essentially two types of investment bonds – onshore and offshore. Onshore bonds are issued by UK insurance companies whereas offshore bonds are issued by offshore companies though these companies are usually connected to UK insurance companies as associated businesses. The tax jurisdiction in which these offshore bonds are issued is typically in the Channel Islands, Isle of Man and the Dublin Financial Services Centre.
Onshore bonds are taxed at the source. UK insurance companies pay Corporation Tax on their income and capital gains so the investor is deemed to have paid basic rate Income Tax at a rate of 20% at source.
Therefore when the bond is fully or partly encashed, if there is a chargeable gain it becomes subject to Income Tax only if the investor is a higher rate taxpayer. The investor receives a deduction for basic rate tax and only pays the difference between higher rate (40%-45%) and basic rate tax (20%) resulting in a tax charge of 20%-25% on the eventual chargeable gain.
Offshore bonds, on the other hand, are not taxed internally therefore the investor is not deemed to have paid basic rate tax at the source so the potential Income Tax charge on a chargeable event can be as much as 45%.
Chargeable gains, otherwise known as chargeable event gains, are taxed in the same way whether they are UK or offshore bonds under UK insurance taxation legislation. It is important to understand that the investor will only pay one tax on investment bond gains and that is Income Tax.
That’s why it is equally important to understand that the taxation is applied to a chargeable gain as opposed to a capital gain on which Capital Gains Tax is payable. Investors often misunderstand this distinction probably because their description chargeable gain is so similar to capital gain. The tax calculation on the chargeable gain can be quite complex too. That’s why it is usually advisable to get advice from a financial planner or a personal tax specialist.
Investment bonds are usually created with a series of identical policies e.g. 100. These are known as segments. So a bond which has 100 segments is in effect 100 policies grouped into one.
So what are the five easy ways to mitigate taxation on investment bonds?
1. If only a partial encashment (surrender) of the investment bond is being made, then consider encashing full segments or partial segments for the same amount of money withdrawn. For example, if 10% or £10,000 is to be withdrawn from a bond worth £100,000 then it can be taken by fully encashing 10 out of 100 segments (10%) or instead 10% of each of the 100 segments can be surrendered. The same amount of money is withdrawn but the two tax calculations of the chargeable events will usually produce totally different results. One calculation may produce a chargeable gain and the other a loss! Remarkable but true.
2. Assign (gift) a bond in full or in part to a lower or zero rate taxpayer such as a spouse or a child. The assignment or gifting of a bond is not classed as a chargeable event therefore no tax is chargeable. This means that if the bond has a chargeable gain that gain could be subject to a lower rate of Income Tax or even zero taxation when subsequently encashed by the assignee (the recipient of the gift). For this to be effective, the assignment must be a genuine and unconditional gift, i.e. the funds mustn’t be returned to the original owner following the encashment.
3. If you are a higher rate taxpayer, surrender your bond in a year when you are a basic rate taxpayer or a non-taxpayer in order to avoid an Income Tax charge or at least reduce it.
4. If you are going to invest in an offshore bond ensure you appoint younger people as lives assured e.g. children of the policy owners. The policy owners are automatically appointed as lives assured but additional people may be added as lives assured too. It is important not to confuse policy owners with lives assured. An individual such as a child may be added to the bond as a life assured without actually owning the bond. The benefit of having much younger lives assured is that the bond doesn’t then need to be automatically surrendered on the death of the policy owner/s. It can potentially be surrendered many years later or assigned to a lower rate taxpayer or non-taxpayer. This will potentially save taxation or at the very least defer its payment for many years. Tax deferred is tax saved after all.
5. Again if it is an offshore bond, consider gifting segments of your bond to children when they are in further education and not employed as they can offset their otherwise unused personal tax allowances against chargeable gains from offshore bonds potentially reducing or eliminating the Income Tax charge entirely.
Investment bonds do have a place in financial planning and are particularly relevant under the following scenarios;
- Inheritance Tax planning e.g. insurance company IHT mitigation plans.
- Long term tax deferment for periods of 20 years or potentially much longer.
- Non-UK tax resident British citizens i.e. expats who may claim 100% relief against taxation known as time apportionment relief for the period they reside abroad.
- All other major taxation reliefs and allowances used up already e.g. pensions and ISAs maximised.
- Potential avoidance of care fees as insurance policies including investment bonds are not included in the local authority financial assessment for care fees. However, this must not fall foul of the deliberate deprivation of assets rule. In other words, the saving has to be incidental and not deliberate.
So do invest in investment bonds when they particularly suit your individual circumstances but make sure you minimise the impact of taxation on them. After all, that’s one of the primary reasons for investing in such plans. You know it makes sense.*
*The value of investments can fall as well as rise. You may not get back what you invest.
The contents of this blog are for information purposes only and do not constitute individual advice. You should always seek professional advice from a specialist. All information is based on our current understanding of taxation, legislation and regulations in the current tax year. Any levels and bases of relief from taxation are subject to change. Tax treatment is based on individual circumstances and may be subject to change in the future. This blog is based on my own observations and opinions.