An onshore bond is simply a tax wrapper - you may have clients that are more suited to an onshore bond than an offshore bond or a collective and so on, as each client is different.
However, onshore bonds can offer significant tax advantages to the right investor and, coupled with an effective exit strategy, can prove to be ideal.
One question when a client wants to withdraw money from the bond is, Should they use the 5% allowance or take total segment surrenders? The answer is, It depends! Before we look at a few examples, let’s consider the taxation of an onshore bond fund.
An onshore bond will pay some tax within the fund. Some may consider this a disadvantage but it can be an advantage. A life fund pays corporation tax on the income it receives and any gains it makes. Rental income and interest (fixed interest stocks) are taxed at 20%, UK dividend income is exempt with any capital gains achieved by the funds also being taxed at 20%. Until 31 December 2017 companies were able to apply indexation relief to these realised gains, but changes brought about by the Finance (No 2) Act 2017 mean that indexation cannot apply beyond 1 January 2018 – meaning the full 20% will now apply.
These taxes are equivalent to the 20% basic rate of income tax and, as a result, this is treated as being paid within the fund. However, even with indexation being frozen, the actual rate paid may be lower than 20% and generally around 16%-18% (depending on the type of assets held, the investment performance and the prevailing economic conditions).
A bond can grow without any personal tax charge and without any need to disclose income or growth providing withdrawals are within the 5% allowance. This makes bonds ideal for those who want a straightforward investment and minimum paperwork.
Also, no tax charges apply for any fund switches carried out within the bond wrapper when changing the underlying investment. This can favour those seeking active management or who want to periodically re-balance their investment.
Each year, a policyholder can take withdrawals of up to 5% of the premium paid in that year plus 5% of any premium paid in any previous years without an immediate liability to income tax. This is known as the ‘tax-deferred withdrawal’ facility and any allowance not used can be carried forward to future years. If no income is taken in year one, then 10% is available in year two and so on.
As well as the 5% allowance there is an overall maximum limit. Once 100% of the cumulative allowance has been used then any further withdrawals, regardless of the amount, are considered a chargeable event. So, for example, withdrawals of 5% each year can be taken for twenty years, 4% each year for 25 years and so on.
For tax purposes, withdrawals within the 5% allowance are considered return of capital.
This means that a policyholder can take annual withdrawals of up to the 5% allowance without reducing any of the following: