When investing tax-efficiently, investors should first use their two main annual allowances: £15,240 in individual savings account and £40,000 in pensions. But if you have more money to invest, or are near the pensions lifetime allowance of £1.25m - set to fall to £1m next year - you will need to consider other tax-efficient options.
These include investment bonds and last week we looked at the case for offshore bonds. But because of the high costs involved with offshore bonds you should only consider them if you have £100,000 or more to invest.
By contrast, onshore investment bonds, domiciled in the UK, have similar tax advantages but generally have cheaper charges so might be suitable for someone with a smaller amount of money to invest.
And onshore bonds are covered by the UK Financial Services Compensation Scheme (FSCS) in the event of failure of the provider, which is not the case with offshore bonds, which are covered by whatever scheme is in place in the jurisdiction where they are domiciled. As onshore bonds are life insurance contracts the FSCS will cover 90 per cent of your claim with no upper limit. This is generous compared with investments held outside an insurance product for which the FSCS awards up to £50,000 per person per company.
They are life insurance plans, for which the life insurance element is usually 101 per cent of the bond value at the date of death. Most investment bonds also allow more than two lives assured to be named, reducing the chance of the bond ending prematurely.
With onshore bonds the basic rate tax of 20 per cent is already paid, meaning they are not suitable for non taxpayers unless other benefits such as estate planning or fixed income needs outweigh payment of the equivalent of basic-rate tax within the bond. This makes onshore bonds less tax-efficient than offshore bonds.
An investment bond allows you to take withdrawals of up to 5 per cent of the originally invested amount each year, over and above your annual capital gains tax allowance, which for the 2015-16 tax year is £11,100 (or £22,200 for a couple), and personal allowance. This could, for example, be used as retirement income or to pay annual university costs.
The tax is deferred until the end of the contract, so onshore bonds are useful for higher and additional rate taxpayers who expect to pay a lower tax rate in future.
If the annual 5 per cent allowance is not used every year, it accumulates. For example, after five years of no withdrawals an investor could take up to 25 per cent of the balance they originally invested, tax deferred. So you could build up a cumulative allowance to take a higher income when needed, for example, when reducing working hours or retiring.
Onshore bonds allow you to switch funds within them without incurring capital gains tax, unlike funds held outside a tax wrapper, and some providers do not charge you to switch.
Onshore bonds can be used to pass on assets. If you gift a unit trust to someone you have to pay capital gains tax on the profits, but if you assign an onshore bond you do not pay tax on the gains at that point. Rather, the recipient will pay income tax at their marginal rate on it when they draw it down. If you survive for seven years the recipient will not incur inheritance tax.
A trust invested in an onshore bond is also a good way to give assets to someone but not give them full immediate control over it.
If you lived abroad for some of the time you held the bond and weren't a UK resident for tax purposes chargeable gains are reduced. "For example, if a bond has been held for 20 years and during that time the investor spent five years working overseas (and was not a UK tax resident), the chargeable gain would be reduced by 25 per cent," says Richard Hulbert, an analyst at Defaqto.
The capital value of onshore and offshore bonds does not count as part of your estate when you are being assessed by your local authority for care costs, although the income produced by the bond is included. However, if it is believed you invested in the bond specifically to remove this money from the assessment it will fall foul of this.
Some onshore bonds offer income guarantees which must be selected at the start of the bond and can't be varied afterwards. "The guaranteed income is paid for life, regardless of how long the bond holder (and potentially their spouse) lives, and will continue even if the fund itself is exhausted," says Mr Hulbert. "This makes them useful for providing security to those in pension drawdown."
However, bonds with guarantees are likely to cost more than standard onshore bonds and tend to offer a smaller choice of funds - typically 10 or fewer.
Some onshore bonds are divided into segments each of which counts as an individual policy, so one bond could be used to assign segments to many different individuals. However, around a third of onshore bonds don't offer segmentation, so if you want this check before you invest.
"Even where there is no initial need, it is sensible to segment a plan at inception as this gives far more flexibility for financial planning in future years," says Mr Hulbert.
Top-slicing When a basic-rate or non taxpayer encashes either an offshore or onshore bond and this pushes some of their income that year above the higher or additional rate tax threshold, they can benefit from a spreading mechanism known as top-slicing. This spreads the gain for tax purposes. The gain is divided by the number of complete policy years an offshore bond has been held, or since the last chargeable event with an onshore bond, to give an annual equivalent. This is then added to total income received by the bondholder in the year of encashment to determine whether there is any additional tax to pay. You can benefit from top-slicing relief if you do not pay higher or additional rate tax on other income (excluding the gain) but when the gain is added you become subject to higher or additional rate tax. "If you face an additional income tax liability you could also potentially reduce or eliminate it by transferring the bond into the name of a lower-earning spouse before encashing, or by encashing over more than one tax year," adds Patrick Connolly, certified financial planner at Chase de Vere. Example Annabel has taxable income of £31,250 for the tax year 2014-15. She cashes in her investment bond after 10 years which results in a £10,000 chargeable gain. Her taxable income and chargeable gain together equals £41,250, with £9,385 of the chargeable gain falling into her higher-rate tax band. Annabel's tax liability in respect of her chargeable gain is therefore £9,385 x 20% = £1,877. During the 10 years there were no previous chargeable gains so Annabel can divide her gain of £10,000 over 10 years, which equals £1,000. This top-sliced gain is then added to Annabel's taxable income to determine how much of the chargeable gain falls into her higher-rate tax band and then multiplied by the 10 years to determine how much is taxable. Taxable income plus top-sliced chargeable gain = £31,250 + £1,000 = £32,250 Amount falling into higher-rate tax band = £32,250 - £31,865 = £385 Amount subject to personal taxation = £385 x 10 years = £3,850 Tax payable on chargeable gain = £3,850 x 20% = £770 This is a saving of £1,107 when compared with the tax liability Annabel would have had if top-slicing had not been used. Source: Legal & General |
Investing
When choosing an onshore bond you should consider include the provider's financial strength, by looking at its AKG rating. "Onshore bond providers tend to gain good ratings and currently 45 per cent of the UK providers have the strongest ratings of A or B+," says Mr Hulbert.
In terms of providers, Danny Cox, chartered financial planner at Hargreaves Lansdown, suggests products offered by Aviva, Legal & General and Zurich. Defaqto awards its five star rating to products including the Zurich Assurance Sterling Investment Bond which has a financial strength rating of B+ and offers access to 250 funds with unlimited switching.
Defaqto rates onshore bonds with one- to five-star ratings according to a number of criteria including financial strength trust facilities and choice of funds.
Defaqto five star rated onshore investment bonds
| Bond | Financial strength | No of funds available | Free switches | Trust facilities | Maximum age to open bond |
| AXA Wealth Investment Bond | B+ | 296 | unlimited | 7 | 84 |
| Canada Life CanInvest Select Account | B+ | 152 | unlimited | 5 | unlimited |
| Canada Life Flexible Investment Bond | B+ | 152 | unlimited | 5 | 89 |
| Old Mutual Wealth Collective Investment Bond | B+ | 1250 | unlimited | 8 | 85 |
| Prudential Investment Plan | A | 149 | unlimited | 6 | 84 |
| Scottish Widows Investment Bond | B+ | 91 | unlimited | 6 | 80 |
| Standard Life Onshore Bond for Wrap | A | 159 | unlimited | 9 | 89 |
| Standard Life Tailored Investment Bond | A | 184 | unlimited | 9 | 84 |
| Zurich Assurance Sterling Investment Bond | B+ | 250 | unlimited | 7 | 79 |
Source: Defaqto
Things to consider before you invest
You should not consider onshore bonds if you have not used up your other tax efficient allowances including your annual capital gains tax CGT allowance, for example, by holding low or non yielding assets and selling units/shares in these when necessary for income. This means onshore bonds are mostly suitable for higher and additional rate tax payers.
Most investment bonds have a sliding scale of penalties should you decide to withdraw during the first five years, which can be as much as 10 percent in the first year. You should not consider onshore bonds if you need access to your capital in the short-term.
Where an onshore bond is paying the adviser fees this forms part of your 5 per cent tax deferred allowance, so your benefit is reduced to 4 per cent. However, around 43 per cent of onshore bonds allow for adviser charges to be taken before investment, so you can preserve your 5 per cent allowance.
The funds available to invest in onshore bonds tend to be more limited when compared to the range offered by fund platforms, and other types of investments are generally not available.
If you invest in non standard assets there maybe additional charges as well as an initial and administration fee, and you also have the costs of the investments held within the bond and your financial adviser's fee. You may incur other charges on top of these depending on the nature of the bond.
Some onshore bonds offer access to a discretionary fund manager but this is more expensive. As well as the discretionary manager's fees which are probably more than those on funds, there may be an additional administration charge.
You can buy some onshore bonds directly, but there is a wider choice if you go to an adviser.
