What’s the point of investment bonds? A beginner’s guide

Investment bonds are single-premium life insurance contracts sold by big name insurance companies, and they can be attractive for tax planning. For many years these products were widely pilloried, largely for their excessive charging structures; but their fees have been modified and, although not popular, they can be very useful in certain circumstances.

The primary advantage of investment bonds is that they allow withdrawals of 5 per cent of the original investment per year for 20 years without incurring an immediate tax charge. The tax is deferred and becomes payable when the bond is cashed in or matures. Any withdrawal allowance not used can carry over to the following tax year.

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The opportunity to defer income tax is helpful to higher rate taxpayers who want to delay payment until they fall into a lower tax band, such as in retirement, and to investors who have already used up their annual capital gains tax allowance.

Handsome benefits

It can also be used to avoid the loss of the personal allowance where income exceeds £100,000, as withdrawals from these bonds do not count towards the threshold. The personal allowance is reduced at the rate of £1 for every £2 of income exceeding £100,000 a year.

The second big attraction of investment bonds is that policyholders are not liable to basic rate tax on any income, and nor are gains made within the bond subject to capital gains tax (CGT). Instead, gains and income on the underlying funds in this type of wrapper are subject to UK life fund taxation at 20 per cent, which is automatically deducted internally. What that means is that in practice, people who are basic rate taxpayers when the bond matures or is encashed pay nothing more.

Furthermore, the bond itself can be assigned to another party without triggering a chargeable event, provided no cash changes hands. Consequently, a higher-rate taxpayer can assign the bond to a spouse or partner without the risk of CGT, which may be useful if the partner is a basic rate taxpayer or a non-earner.

It is also possible to arrange for a surviving or former spouse to have an income from the bond, while gifting the capital sum direct to children or other named beneficiaries.

Arguably, these plans have a place in a wealthy person’s portfolio – they can withdraw 5 per cent a year with income tax deferred, leaving their capital gains tax annual allowance – £11,700 for 2018/19 – to be used against gains made from other investments.

Mud sticks, however. Many associate these products with those marketed in the dark days of financial adviser commission, which was abolished by the Regulator’s Retail Distribution Review in 2012. To accommodate commission payments of as much as 9-10 per cent, the plans carried horribly opaque and exorbitant charges.

In contrast, today’s investment bond charging structures look much like any tax wrapper, with fees of perhaps 1 per cent all-in, comprising around 0.6 per cent for the fund charges and 0.4 per cent for the tax wrapper.

Isas and pensions first

Nonetheless, most advisers prefer to exhaust their clients’ allowances for Isas, pensions and VCTs first. ‘We’ve never had huge demand for investment bonds from our clients as they are so complex and, over time, they have lost some of their attractiveness – especially now the Isa allowance is so generous,’ says Darius McDermott, managing director at Chelsea Financial Services.

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‘They could still be relevant for those lucky enough to have used up all their Isa and pension allowances, or who are able to do some detailed tax planning. Investors can withdraw 5 per cent of the amount invested each year without paying any immediate income tax, and if the 5 per cent allowance is not used, it accumulates. So, after five years of no withdrawals, an investor could take 25 per cent of the balance originally invested, tax deferred. This can be useful for higher or additional rate taxpayers who expect to be in a lower tax band in the future.’

McDermott points out that the other particularly topical issue is that the capital value of the bond does not normally count as part of an individual’s estate when they are being assessed for long-term care costs. He adds: ‘But (and it is a big but) if it is believed you invested the bond especially to remove this money from the assessment, it will fall foul of the exemption.’

Today, investors in the modern plans can avail themselves of the insurers’ ‘open architecture’ platforms offering a choice of funds to put together a portfolio of funds, and can move money from fund to fund without creating a chargeable gain or income tax liability, in a similar vein to a self-invested personal pension (Sipp).

A with-profits option is sometimes available, but again, the world has moved on from the with-profits structure.

‘With-profits is still an attractive feature,’ says John Lawson, head of financial research at Aviva. ‘Many wealthy people prefer with-profits – not the oldstyle with-profits, but mixed funds that can go up and down and are smoothed by holding back a proportion of the investment returns acquired in the good times so that performance can be topped up in poor years.’ He adds that investment bonds are 100 per cent protected under the FCA, whereas other collective funds such as Oeics are only protected up to £50,000.

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Offshore investment bonds are also available, and typically offer a wider selection of funds. They also differ from onshore bonds in that, instead of being subject to UK corporation tax offset by the provider, they are issued from tax havens such as the Isle of Man, Luxembourg or the Channel Islands, where no tax is charged on the funds.

Loan trusts

One use of investment bonds is in the setting up of so-called loan trusts for clients who want to address inheritance tax (IHT) planning but do not want to relinquish access to their capital. The bond is put in a trust that allows investors to access their original capital, retaining control, but growth in the bond is not included in their estate for IHT purposes.

There are two types of loan trust – absolute and discretionary. Under an absolute trust, the beneficiaries can demand the trust fund when they reach age 18 (16 under Scottish law) and the trustees have a legal obligation to inform them of the trust fund’s existence. Under a discretionary trust, the trustees decide who benefits and when.

As there is no gift – just a loan to the trust – any outstanding loan forms part of the settler’s estate for IHT purposes, but the loan can be waived in part or in full at any time. Under an absolute trust, any amount waived which is not exempt will be a Potentially Exempt Transfer (PET), and under a discretionary trust it will be a Chargeable Lifetime Transfer (CLT). This is because the individuals are named under the former but are at the trustees’ discretion under the latter.

Loan trusts can be a good off-the-shelf solution, says Ian Dyall, head of estate planning at adviser Tilney Group. ‘There are no accounts to do – attractive for the trustees who will just buy it and hold it. They can move investments around, and can continue to take the 5 per cent income, all without completing a tax return. So for discretionary trusts there is little reporting to do.’ However, he adds, these structures tend to be over-used. ‘They are a good solution but are often put in place where the client will never need the income from these withdrawals.’

The biggest providers such as Prudential, Aviva, Legal & General, Scottish Widows and Standard Life are keen that this business is transacted by advisers. Not all providers let you take out new plans or top up plans without a new contract when funds are depleted. 

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