What is an investment bond?

Investment bonds have similarities to other investments such as ISAs – you can pay money in and take money out as and when you want.  Like ISAs, bonds follow their own set of tax-rules that set out how they work and when you might have to pay tax.  ISA tax rules are more generous than those for bonds (though you are limited as to how much you can save into an ISA each year), so most people only start considering investment bonds once they’ve used up their ISA allowance.

Investment bonds can also help with trust and estate planning, for example, a bond may be the best way to meet your inheritance planning needs.

The rules for investment bonds mean that they are usually treated as single premium life insurance policies (because most pay out a small amount of life insurance upon death), but they are really an investment product.

Fund choice

When you take out an investment bond, you’ll usually invest a lump sum into a variety of available funds.  The funds and other investment options that are available to you vary by provider. You should consider the funds and investment options you want, before choosing who to invest with.  When you cash-in an investment bond, the amount you get back depends on how well, or poorly the investments have done.

Types of investment bonds

There are two types of investment bond: Onshore and Offshore. The main difference between them being how the tax rules are applied.

Onshore (UK) investment bonds

The tax rules for onshore bonds mean that:

• The underlying fund selection can be switched without generating a personal liability to capital gains tax as the switch takes place within the bond itself
• Any dividend income received within a fund from UK equities is not subject to further tax for a basic rate tax paying investor
• The bond provider pays tax of 20% on any interest and other income received, such as rental income, from the funds available in the bond
• The bond provider pays 20% tax on any capital gains made by funds available in the bond

All this means that HM Revenue & Customs treat the tax paid as being the same as the basic rate income tax even though the actual tax paid in the bond may be less.  In practice, this means that people who are basic rate taxpayers when the bond matures or is encashed pay no additional tax.  If you’re higher or additional rate tax payer or become one when the bond is encashed, then there could be a tax liability.

Offshore (International) investment bonds

Offshore is the common term for investment bonds issued by companies outside of the UK.

The tax rules for offshore bonds mean that:

• The underlying fund selection can be switched without generating a personal liability to capital gains tax as the switch is done within the bond itself
• Any dividend income received within a fund from UK equities is free of tax.  Dividends from other countries may be subject to a withholding tax and this cannot be reclaimed
• HMRC do not make any allowance for any withholding tax suffered under an international bond

The different way of taxing an offshore bond means that it might grow faster than an onshore bond, although this isn't guaranteed. However, you will pay income tax on any gain at your highest marginal tax rate because with an offshore bond, you’re not treated as having paid basic rate tax on any gain.

Changes that can trigger tax

Certain transactions are treated as chargeable events. When one of these occurs, a chargeable gain calculation is made to establish if any tax must be paid:

• When someone dies and the death benefit becomes payable
• Transferring ownership (called assignment) for money or money’s worth
• When the bond reaches maturity (if applicable)
• If you withdraw more than the 5% a year tax-deferred allowance
• You cash-in (surrender) all of your bond or individual policies within it

If a chargeable gain arises it will be assessed on income tax, not Capital Gains Tax. This will be based on your tax position at that time, regardless of whether you have paid higher rates of tax in the past.

Tax-efficient withdrawals: 5% tax-deferred allowance

One of the main advantages of investment bonds is that you can take withdrawals of up to 5% of the original investment every year, without having to pay an immediate tax charge. These withdrawals are treated as a return of capital – the tax is deferred and only becomes payable when the bond is cashed in or matures, if any liability arises. Any unused withdrawal allowance is cumulative can be carried over to the following tax year.

Deferring income tax can be helpful to higher and additional rate taxpayers who want to delay payment until their circumstances change, such as falling into a lower tax band when they retire. It may also help investors who’ve used up their annual capital gains tax allowance.

Withdrawing more than the 5% allowance would result in a chargeable event. The excess amount that’s been withdrawn would be a chargeable gain and could be subject to income tax.

Assigning bonds

Investment bonds can be assigned to someone else without triggering a chargeable event, as long as cash doesn’t change hands. This means that a higher or additional rate taxpayer can assign the bond to a spouse or partner without triggering a tax charge. This is especially beneficial if they’re a basic rate taxpayer or a non-earner.

Income from a bond

Any withdrawals are paid to the policy owner. So if the bond is assigned to a new owner, they can take withdrawals and make use of any unused 5% allowance to defer the tax payable.

What are the risks?

The value of your investment can go down as well as up and you may get back less than you invest. Tax rules depend on the type of investment and individual circumstances and may change.