Onshore investment bonds enjoy taxation advantages over other investments: income paid out by the bond is deemed by HM Revenue & Customs to be net of basic rate income tax- hence the basic rate tax payer has no further tax to pay. The funds themselves benefit from being free from capital gains and income tax, provided you are the owner of the investment bond.
It is possible to receive a regular income by taking withdrawals of up to 5% of the initial investment amount (for the first 20 years, or until the original capital invested is returned if withdrawals of less than 5% per annum are taken), tax deferred. This 5% per annum allowance of the original capital invested is cumulative- so if not used in one year can be carried forward to the next. Hence if you did not use your 5% allowance for the first three years of being invested, in the fourth year you could carry the unused three years forward and add it to the fourth year’s allowance, meaning 20% can be withdrawn with no immediate liability to income tax.
If the value of the withdrawals you receive exceeds 5% (cumulative) of the original investment amount, a “chargeable event” is said to have occurred. Chargeable events can also be triggered by death or assignment for money’s worth. If you exceed your cumulative 5% withdrawals and trigger a chargeable event, you will be taxed at your highest marginal rate of income tax on the amount above 5%. If you are a higher rate taxpayer, you would be taxed at 40%, less the basic rate of tax on savings deemed to have been paid already at 20%. If you are an additional tax payer, you would be taxed at 45%, less 20%.
Investment bonds are not considered suitable for non-taxpayers or for starting rate taxpayers (ie those paying income tax at 10%) since they are unable to reclaim the basic rate tax deducted from the bond. However, if the non or starting rate taxpayer is married to a higher rate bondholder, assigning the bond can create a valuable tax planning opportunity (see the “Assigning a Bond to a Spouse” section, below).
In some circumstances, it may be more tax efficient to fully surrender individual segments held within an investment bond rather than take cumulative withdrawals across all segments of the bond. Where cumulative 5% allowances are exceeded then the chargeable gain which results is determined by the amount originally invested, as opposed to the current valuation of the investment bond. In this scenario, you could find that a chargeable gain occurs even if the investment has made a loss. A significant partial withdrawal in excess of the 5% cumulative allowance can create a chargeable event gain which could have been avoided by surrendering segments from the bond instead.
The difference between surrendering segments of an investment bond as against using thee cumulative 5% yearly allowances can be seen using the following scenario:
A policyholder invested £200,000 into an investment bond on 1st May 2011. The investment bond was split into 100 segments, so each segment was worth £2,000. If the bondholder chose to withdraw 5% from each segment, this would equate to £100 per segment, and would total £10,000 of the amount originally invested.
If the bondholder wishes to withdraw £100,000 on 1st July 2013 (year three) when the bond is worth £220,000, there are two ways they could do this:
1. Taking 5% cumulative withdrawals
If the bondholder were to take a partial surrender across all segments, the chargeable gain would be calculated as:
£100,000 – £30,000 (3 years of £10,000) = £70,000
The “top sliced gain” would be £70,000/3 = £23,333.33
In this example, the current valuation of the bond is irrelevant since we are using the amount originally invested to determine the cumulative 5% withdrawals. The reason 3 years is used for the 5% allowable withdrawals despite the fact the investment bond has only been held for 2 years and 2 months is because the withdrawal is deemed to take place at the end of the policy year, giving 3 years instead of 2.
2. Full surrender of segments
Alternatively, the bondholder could surrender in full sufficient segments to release the required £100,000. Using the current valuation at the time of encashment, each segment is valued at £2,200. Surrendering in full 46 segments would yield £101,200, slightly more than the £100,000 required.
The chargeable gain for each segment is the current valuation per segment (£2,200) less the original value of each segment when the investment bond was first taken out (£2,000) = £200
The full surrender of 46 segments gives a chargeable gain of 46 x £200 = £9,200.
This is then divided by the number of full policy years the segments were in force, which is 2 to give a Top Slice of £4,600.
You can see, therefore, that there is a significant difference in tax efficiency between the two methods of withdrawing 5% across each segment and surrendering in full enough segments to release the required amount.
Age Allowance Trap
For those aged over 65 who trigger a chargeable event by exceeding the 5% withdrawals, they may find themselves in an “Age Allowance Trap”. An “Age Allowance” is an increased amount of personal allowance for those aged over 65. The Age Allowance can be reduced by £1 for every £2 of income over the allowable income limit which can reduce your Age Allowance to the same as the basic personal allowance. Please note there is a second Age Allowance threshold for those over 75. A key benefit of investment bonds is that cumulative withdrawals of up to 5% per annum of the original sum invested are disregarded when calculating income which would reduce a person’s age-related allowances. This gives bonds an important advantage when compared to other sources of income.
When an investment bond is fully surrendered any profit made (including the 5% withdrawals) will be added to the income in that final year. Depending on how much the profit is and how much your income is, this could wipe out any higher age-related tax allowance in the year you cash in your bond. For this reason careful planning is required upon surrender and it may be necessary to make partial surrenders in different tax years or wait until your taxable income does not jeopardise any age related personal allowance once gains are added.
Personal Allowance Trap
The loss of the personal allowance when income exceeds £100,000 introduced a comparable issue to the ‘age allowance trap’ outlined above. Under current rules, the personal allowance is reduced at the rate of £1 for every £2 an individual’s taxable income exceeds £100,000 a year. Withdrawals from the bond do not count towards the £100,000 threshold, but as with the age related allowances, any chargeable gains (ie on death, full surrender or withdrawals in excess of the cumulative 5% yearly allowances) will be added to income when a chargeable event gain arises. If this income exceeds £100,000, the personal allowance can be eroded.
Top Slicing Relief
Top slicing relief allows the bondholder to spread the investment gains over the number of years the bond has been held. The process of top slicing is efficient from a taxation point of view, since you are only taxed when a chargeable event occurs, as opposed to being taxed each year, at source, as you would be for savings interest or share dividends.
When an investment bond is finally encashed, there may be a liability for income tax on any amount over and above the level of your original investment, in other words the growth. This tax may be mitigated by applying “top slicing” relief. The gain is divided by the number of complete policy years the bond has been held for to give an “annual equivalent”. This is then added to total income received by the bondholder in the year of encashment to determine whether there is any additional tax to pay. To do this you need to identify how much of the “annual equivalent” falls in the higher and, if applicable, the additional rate tax band. If the profit slice pushes the bondholder into the higher rate tax threshold, there would be additional tax of 20% to pay on the amount falling in the higher rate tax bracket. The amount of total tax payable is then calculated by multiplying the amount of tax on the profit slice by the number of policy years the bond has been held for.
With careful planning it can be possible to time the encashment of a bond to coincide with a tax year where income is less than in previous years- for instance if a retiree became a basic rate tax payer when previously they were paying higher rate tax, a bond encashment in the year of being a basic rate taxpayer would be advantageous and could mean not having to pay any additional tax on surrender.
Assigning a bond to a spouse
Where the policyholder is a higher-rate taxpayer and the spouse is a basic rate or non-taxpayer, it creates a valuable tax planning opportunity. This is because the investment bond can be transferred by means of a deed of assignment by the higher rate taxpayer to the non taxpaying spouse without triggering a “chargeable event”. This would mean that further liability to tax can be avoided following the assignment.
Making a pension contribution to reduce tax from a bond
To mitigate chargeable gains arising from surrendering an investment bond, making a personal pension contribution can reduce taxable income prior to performing the ‘top-slicing calculations’, which determine to what extent higher rate tax is due on any chargeable gain. The pension contribution can move the top-sliced gain from being subject to higher rate tax to below the extended basic rate tax limit. The grossed up pension contribution can extend the basic rate tax band so that after top-slicing, a chargeable event gain can fall into the basic rate tax band. It is also possible to use a pension contribution to move a top-sliced gain down from the additional rate of income tax to the higher rate.
Here are the four steps you would need to take to reduce tax incurred from triggering a chargeable event from an investment bond surrender by making a pension contribution:
- Identify all taxable income assessable to the higher rate tax bands.
- Calculate the top sliced gain from the investment bond.
- Work out the pension contribution needed to move some or all of the top sliced gain into the lower tax band.
- Make sure the personal pension contribution is made in the same tax year as the bond gain is taxed.
Investment Bonds and retirement planning
An investment bond can be a very useful vehicle when used in conjunction with pensions for retirement planning. This is particularly the case for individuals who are currently higher rate taxpayers, but expect to become basic rate taxpayers when they retire. Even if you and any spouse are a higher rate taxpayer in retirement, you can still withdraw 5% of the original amount invested for up to 20 years without incurring a further tax liability. Since the allowance is cumulative, you could withdraw 4% per annum for 25 years. This ability to carry forward unused relief means that a bond holder who has not used their 5% withdrawals for a year, can withdraw up to 10% in the second year with no immediate liability to taxation- regardless of their tax position.