Investment bonds – a new world of opportunity

This article is taken from the spring 2025 edition of Equinox. You can view the full magazine here.

In recent times, Individual Savings Accounts (ISAs) and general investment accounts have been the go-to wrappers for clients with significant sums to invest.

The logic was clear to see – tax-free income and growth within the ISA wrapper and the chance to use capital gains tax (CGT) annual exemptions of up to £12,300 per annum. Not to mention attractive CGT rates of just 10% or 20% depending on income tax status.

Now, however, annual exempt amounts have been slashed to £3,000 and tax rates aligned with residential property at 18% and 24% respectively. All of which serves to make a slightly out-of-fashion alternative solution suddenly appear far more attractive…investment bonds.

What are investment bonds?

Investment bonds are life assurance-based investment contracts with a difference. They are subject to income tax, rather than capital gains tax. However, they are not subject to tax in the hands of the investor, until what is known as a ‘chargeable event’ occurs.

Contracts can be either onshore or offshore. An onshore bond is issued by a UK life assurance company. It follows a special tax regime where basic rate income tax is considered paid within the fund. Investors only pay additional tax on encashment if the taxable gain pushes their income into a higher tax band. Within the wrapper, interest, gains, and rental income are taxed at 20%, but UK dividends are not subject to further tax.

Offshore bonds are potentially even more tax efficient. Based in offshore jurisdictions like the Isle of Man, they suffer no UK tax on interest, dividends, or growth in the underlying assets, although overseas dividends may be subject to non-reclaimable withholding tax. Instead, the entire UK tax liability is calculated when the chargeable event occurs.

What happens when a chargeable event occurs?

Whilst there are numerous chargeable events, the most common is the encashment (known as ‘surrender’) of the bond. The total gain on the investment is calculated by taking the current value of the policy, adding any previous tax deferred withdrawals (see below for more details) and deducting the amount originally invested.

However, that gain can then be ‘topsliced’, which means it is divided by the number of years since the bond was opened. The tax liability is calculated with reference to the topsliced gain. It is then multiplied back by the number of years the bond has been open to establish total tax payable.

Example:

A gain of £50,000 on an onshore bond which had been in force for 10 years would contain a top-sliced gain of £5,000.

So, if the investor had an existing income of £40,000, they would remain within the basic rate band after adding the top-sliced gain. There would therefore be no further tax to pay.

If, however, the investor had an existing income of £60,000, making them a higher rate taxpayer, then an additional tax of £1,000 would be due on the top-sliced gain. If we then multiply this by the number of years the bond was in force, the total tax due would be £10,000.

What other advantages do they offer?

Both onshore and offshore bonds allow the use of the savings starting rate band of £5,000 against the top-sliced gain. Holders can also use the personal savings allowance of £1,000 for a basic rate taxpayer and £500 for a higher rate taxpayer against it, which increases the opportunity for efficient tax planning.

Other benefits include the facility to take tax-deferred withdrawals of up to 5% of the original investment per annum on a cumulative basis. These payments only become potentially taxable when a chargeable event occurs. This can be very tax efficient if the bond is encashed at a time when the holder pays a lower rate of income tax, or potentially at a time when they have become a non-UK resident. It should be noted that in the latter scenario, the gain may be subject to overseas taxes. In addition, there are anti-avoidance measures which may apply if the non-residence is only temporary.

The bond can also be assigned to another party, such as a family member, by way of gift prior to encashment. In this case the income tax liability will be assessed against the assignee. This can therefore offer further planning opportunities should the assignee pay a lower rate of tax than the original holder.

Another advantage of investment bonds is that they can be topped up. When a top-up has been paid, the entire gain can still be top-sliced back to the date of inception. Investors can therefore make a relatively low initial investment, add to it at a later date and benefit from full top-slicing relief on any gain made.

Every set of circumstances is obviously different. However, with the recent changes and potential planning opportunities, investment bonds may start to look like an increasingly attractive option once more.

This article is intended as an information piece and should not be construed as advice.