Save money and time on your Insurance Bonds

Insurance bonds are investments offered by life insurance companies. They allow you to invest in a variety of investment funds, unit linked and with-profits funds managed by professional investment managers.

About Insurance Bonds

Insurance bonds are normally designed to produce long term capital growth, but can also be used to generate an income. The minimum investment is typically £5,000 or £10,000. When you buy a bond you will be allocated a certain number of units in the funds of your choice. Each fund will hold a portfolio of investments, such as shares or bonds, and the price of your units - in other words the value of your capital - will normally rise and fall in line with the value of these investments.

Technically investment bonds are single premium life insurance policies. This means an element of life insurance is provided. But it is tiny, typically adding an extra 1 per cent or less to the value of your investment, if it is paid out after your death.

Investment bonds linked to distribution funds (which are geared to produce a regular income by investing in equities, bonds and sometimes property) have become more popular in recent years. These bonds can fluctuate in value, but many have a good record for producing a steady income. However, due to the relatively poor past performance of unit linked funds generally and with profits funds in particular, many investment bonds nowadays tend to offer investors access to funds which invest in a wide range of top performing unit trusts. A portfolio of these funds can be held in a bond and switches made between them when required.

Tax Matters

As bonds are life insurance policies, it is the insurance company that pays tax on income and capital gains. Investors don’t pay capital gains tax on any gains, or basic rate tax on any income. Higher rate taxpayers may become liable to tax at a rate equal to the difference between the basic rate and the higher rate of income tax, but not until they cash in their bonds or make partial withdrawals of over 5% per annum of their original investment. This is because there is a special rule that allows annual withdrawals from bonds of up to 5 % for twenty years without any immediate tax liability.

It is possible to carry these 5% allowances forward, so if you make no withdrawals one year, say, you can take out 10% of your investment the next without triggering a tax charge. When you finally withdraw your money, your gain could potentially push you into the higher rate tax bracket even if you are normally a basic rate taxpayer. ‘Top-slicing relief’ can compensate for this.

Top-slicing Relief

Your total gain (the difference between the amount you invested and the final value of the bond, including any withdrawals) is divided by the number of years you have held the bond to find the average annual gain. If the average gain, when added to your other income, falls within the basic rate tax band, you will have no further tax to pay. If it falls into the basic and higher rate tax band, you will be charged higher rate tax on the part that falls within that tax band multiplied by the number of years you have held the bond. If it all falls into the higher rate tax band, you will have to pay extra tax on the whole gain. However, you may be able to avoid paying higher rate tax by delaying the encashment of your bond until you are a basic rate taxpayer, say after retirement, or by gifting it to a spouse or partner who pays less tax.

Is investing in an insurance bond worthwhile for you?

You might find investing in an insurance bond worthwhile in the following situations:

• You are a higher rate taxpayer, seeking an extra income. You can take advantage of the rule that allows 5% withdrawals each year for twenty years, without any immediate tax liability.
• You are retired and want a supplementary income, but you are in danger of falling into the age allowance ‘trap’. 5% withdrawals from investment bonds do not count towards your income, so will not affect your age allowance. Before you cash in your bond you will need to consider how your age allowance might be affected in that year.
• You are an active investor with a large investment portfolio and you are already using your annual capital gains tax allowance. Using an investment bond to manage your money will mean you will not be liable for capital gains tax when you make switches between funds.
• You are trying to shelter capital from inheritance tax through a discounted gift trust or loan trust. Life insurance companies often sell packaged products where these trusts are linked to investment bonds. The advantage of using an investment bond is that the investment income in trusts will generally be taxed at 40 per cent, but when it is accumulated within a bond it is only taxed at 20 per cent.
• You are an investor who is likely to need long term care. Life insurance policies will not normally be counted as part of your means when your eligibility for local authority funding is assessed.