An investment bond is an insured tax wrapper through which collective investments can be purchased. There are two similar formats, life assurance and capital redemption bonds, although the taxation of each is the same.
The legal ownership of the underlying assets rests with the life company while the policyholder has a beneficial interest.The life company is therefore responsible for taxation on both gains and income during the investment period and the policyholder only meets a potential income tax liability upon final encashment.
The investment bond wrapper provides the policyholder with control over the tax point; the charge to tax can be deferred until full surrender. Typically, higher-rate taxpayers would delay encashment until they paid tax at a lower rate, for example in retirement.
For UK onshore policies, the life company taxation satisfies any basic-rate personal income tax liability. Offshore policies suffer applicable withholding taxes only but do not provide any credit against future income tax.
Withdrawals
The policyholder can withdraw 5 per cent of the original investment per policy year and defer further tax until a ‘chargeable event’ occurs, at which point any growth is taxed on the policyholder through the income tax regime.
The 5 per cent allowance is cumulative up to 100 per cent of the original investment amount. For example, if £100,000 were invested and no withdrawals taken for the first four years, £25,000 could be withdrawn in the fifth policy year without triggering a chargeable event. Similarly, a smaller amount can be withdrawn for a longer period, such as 4 per cent per annum for 25 years.
Chargeable events
A chargeable event occurs with any of the following:
• maturity or full surrender
• partial surrender in excess of the 5 per cent allowances
• assignment of the bond for money or money’s worth
• death of the last life assured.
At a chargeable event, the chargeable gain is calculated using the following formula: current value + previous withdrawals – initial investment – previous excesses
The chargeable gain on full surrenders is counted as being received immediately for tax purposes. The chargeable gain on partial surrenders is counted as being received at the end of the policy year, so therefore may be taxable in the following tax year.
Top-slicing relief
Where a bond has been held for a number of years, top-slicing ensures that the policyholder is not disadvantaged by taking all the gain at once. Top-slicing relief is used where adding the full gain to the policyholder’s taxable income would push them into a higher-rate tax band.
The top-slice is calculated by dividing the total gain by the number of complete years that the bond has been in force. This top-slice is then added to the policyholder’s taxable income to establish what proportion of the bond growth falls into which tax band.
Full and partial surrenders
The tax treatment of full surrenders is outlined in Box 1, but for partial surrenders, a chargeable gain is triggered when the annual cumulative 5 per cent allowances are exceeded. The amount of chargeable gain is the excess over the allowance rather than actual growth, therefore a tax charge may occur even where the bond is showing a loss.
For example, if an investor placed £150,000 into an investment bond in January 2012 and in June 2013 the bond was valued at £135,000, and he then withdrew £50,000 by partial surrender; this would be above his cumulative 5 per cent allowance of £15,000 for the two years the policy has been in force, therefore he must declare a chargeable gain of £35,000, even though the bond itself is currently showing an overall loss.
Where a partial surrender has triggered a chargeable gain it is possible to remove any tax liability by surrendering the entire policy before the end of the policy year. The gain is then calculated based on growth since inception. This is particularly valuable where the partial surrender has resulted in a tax charge but the policy as a whole is showing a loss or negligible gain.
Reducing the tax liability
An efficient way of arranging investment bonds is by using segmentation, typically dividing the bond into chunks of £100 or £1,000. A segmented bond allows more flexibility when surrendering a portion of the original investment. With careful planning the tax charge can be minimised, as shown in Box 2.
Personal allowance trap
The personal allowance is reduced by £1 for every £2 of taxable income over £100,000.This results in the ‘personal allowance trap’ whereby income falling between £100,000 and £118,880 (2013/14) is effectively taxed at 60 per cent.
Top-slicing is used to calculate the direct tax liability but the full chargeable gain is added to income when assessing any reduction in the personal allowance. A bond surrender may therefore result in an indirect tax liability.
This principle also applies to the age allowance trap although the impact is reducing each year due to the rising standard personal allowance.
Assignment
Assigning a bond via gift does not trigger a chargeable event; the entire chargeable gain calculation is passed over to the assignee, including any partial withdrawals.
For example, a higher-rate taxpayer could assign their bond to their basic-rate taxpaying spouse before surrendering the bond. Trustees can assign bonds to beneficiaries before surrender.
Pension contributions
Where a chargeable gain is taxed at higher rates, a personal pension contribution would extend the basic-rate tax band to encompass part or all of the top-sliced chargeable gain and could lead to significant tax savings.
The limiting factors will be the size of pension contribution that can attract tax relief, that is,the policyholder’s relevant UK earnings and available annual allowance.
For example, following on from the case outlined in Box 1, if John made a £440 net personal contribution to his Sipp, this would extend his basic-rate band by £550 gross to £42,000, meaning the entire top-sliced onshore bond gain would fall into basic-rate tax. So the higher-rate tax liability of £1,100 has been completely removed.
Victoria Harman is a chartered financial planner at Hargreaves Lansdown
