What are Investment Bonds?

Investment bonds are offered by life assurance companies and are used to invest one-off lump sum payments. They allow access to a number of funds both internally managed and managed by external fund managers.

Although they are classed as life assurance policies they will only have a minimal amount of life cover – i.e. 100.1% of the policy value at death. One of the benefits is that they allow tax deferral on withdrawals from the policy and can be used in effective tax planning, particularly for higher rate taxpayers

Taxation

When investment bonds are encashed, the profits made are taxed as income rather than capital gains. HM Revenue and Customs deems that basic rate income tax has already been paid at a rate of 20%, so basic rate taxpayers may have no further liability. Non taxpayer and starting rate taxpayers cannot reclaim the tax already paid. Basic rate tax payers have no further income tax liability as long as the gain added to the taxpayer's total income of the year does not push them into the higher rate tax bracket.

Due to the deferral of any tax liability until encashment Investment Bonds are particularly attractive to higher rate taxpayers who know that they will become basic rate taxpayers at some point in the future. This means that during the lifetime of the bond they can make withdrawals and defer the liability on any tax until the policy is encashed. If at the time of encashment the policyholders have become basic rate taxpayers then there is a good chance that they will incur no tax liability.

The 5% rule

Up to 5% of the original investment can be taken from an Investment Bond each year for 20 years without incurring an immediate tax liability. Also, if 5% is not taken at the beginning of the Investment Bond's life, it can be rolled up on a cumulative basis – e.g. if 5% of the original investment is not taken in years 1 to 3, then 20% of the original investment can be taken in year 4 (3 x 5% + 5% for the current year) without an immediate tax liability.

Calculating a chargeable gain

The gain on final encashment is assessed in the tax year in which it occurs. Where no withdrawals have been made the chargeable gain is calculated by deducting the original investment amount from the policy's proceeds (naturally if this is less than the original investment amount no further tax is liable).

Top slicing

Since the chargeable gain may have built up over a number of years, a method of relief known as top-slicing is allowed. This divides the gain by the number of full years the investment bond has been in force in order to give an average gain.

This is then added to the investor's taxable income in that year to ascertain whether there is a tax liability. If after the addition of the top sliced gain the investor's taxable income for that year is still within the basic rate band – then no further tax is liable.

If the top sliced gain pushes the investor's taxable income into a higher rate of tax, then only the portion of the gain that is in the higher rate tax bracket is taxed.

Joint ownership

If a bond is jointly owned, the gain is split in the same proportion as the ownership. Each owner is therefore taxable on their share of the gain. If joint owners are married to each other, HM Revenue and Customs considers that each spouse should be taxed on half of the gain.

Age allowance for the over 65s

The total gain on final encashment will be treated as income for age allowance purposes. Therefore, the whole of the chargeable gain is used, as top slicing relief does not apply in age allowance calculations.