- no tax liability arises until a ‘chargeable event’ (e.g. surrender of the whole or part of the policy; maturity; death) occurs which allows the investment returns underlying the bond to roll-up tax free.
- the owner of the bond can withdraw up to 5% of the initial premium each year (as a partial surrender) without any immediate tax charge (however, such withdrawals are ultimately taken into account on a chargeable event arising, and are thus not ‘tax free’ as is often suggested).
Example 1: Five per cent withdrawals
Ben invests £30,000 in an
investment bond. Ben can withdraw up to 5% of £30,000 ie £1,500 each year
without any immediate tax charge.
Example 2: Inheritance tax and income tax
Tom invests £50,000 in an
investment bond. The life insured under the bond is Tom. On Tom’s death, the
policy matures and the value of the bond forms part of Tom’s estate for
inheritance tax purposes (and an income tax charge arises on any gain made);
but see below.
Chargeable event
When a chargeable event occurs, any gain made on the bond is subject to income tax not capital gains tax. It is generally assumed that the bond owner has paid income tax at the basic rate (20%) on the gain and thus an actual liability only arises where the beneficial owner is liable to income tax at the higher (40%) and/or additional (45%) rates of income tax. For example, a 45% individual taxpayer has an income tax exposure of 25% (i.e. 45% less 20%).
However, so-called ‘top slicing’ relief may apply, in which case the resultant aggregate tax charge may be reduced.
Trusts
In Example 2 above, the bond’s proceeds on Tom’s death fell subject to inheritance tax (40%) which is undesirable. This charge could have been avoided if he had settled the bond on trust (bare trust or discretionary trust).
Example 3 – Investment bond in trust
Tom invests £50,000 in an
investment bond. The life insured under the bond is Tom.
To avoid an inheritance
tax charge on the bond’s proceeds arising on his death he transfers/settles the
bond on a discretionary trust for the benefit of his wife and three children.
In practice, it would have been preferable for Tom to have taken out the bond not on his own life but, for example, on the lives of his three children and settle it on trust. On his death, the bond would then not mature (no tax charges arises) and the bond would continue in existence (theoretically increasing in value). If one or more of Tom’s children required financial help at any time then the trustees would have the flexibility to provide cash either from a surrender of part of the bond and/or utilising the 5% withdrawal facility.
The surrender of the whole, or part, of the bond may precipitate an income tax charge. If at such time the ‘creator’ of the trust (i.e. Tom) is alive, any income tax charge is that of the creator, although he may then recover any such liability from the trustees. If the creator is not alive (or not UK resident) at such time the liability is then that of the trustees, with any gain subject to the 45% trust rate (albeit with a basic rate (ie 20%) offset producing a net 25% liability). Trustees, however, are not entitled to top-slicing relief.
Multiple bonds
Rather than invest in a single bond of, say, £50,000 it can be more tax efficient (and more flexible) to invest in say five bonds of £10,000. This is particularly important where the aggregate amount exceeds the inheritance tax nil rate band (currently £325,000).
Offshore bonds and trusts
It may also be advantageous to consider taking out a bond(s) with an offshore (as opposed to onshore) life insurance company (often the Isle of Man) and, if appropriate, assigning the bond to an offshore (as opposed to onshore) trust. However, this is a complex area, and specialist advice should be sought.
Practical Tip:
Bear in mind that losses can arise on a bond and they cannot be offset against an individual’s capital gains or income.
As with investments generally, seek professional advice on bonds from a suitably qualified and experienced financial adviser if necessary.
