Investment bonds Investment bonds tax issues

Investment bond tax benefits may not be as compelling as they first seem

Investment bonds are often sold on the basis of their tax benefits. 

But the taxation of these products is complex – and the advantages aren't as compelling as they might first appear.

It's also worth remembering that investments should rarely, if ever, be entered into on the basis of tax considerations alone. 

Those in any doubt should always seek financial advice

The taxation of investment bonds

Although all gains and income earned within an investment bond are taxed at 20%, paid directly out of the bond by the insurance company, you can make withdrawals of up to 5% a year for up to 20 years without paying any additional tax immediately.

If you don't use your 5% allowance in a given year, the allowance is carried over to the following year – i.e. if you make no withdrawals in year one, you could draw up to 10% the following year without paying any tax at the time.

So if you're a higher rate or additional rate taxpayer, paying 40% or 45% tax on income in the current tax year, an investment bond can minimise your income tax bill.

However, your tax bill does not disappear entirely. Instead, the tax is deferred – and any additional tax due will be payable at the time you cash in the bond, or when it matures. All capital gains are treated as income at this point. Although tax at 20% has already been deducted, you may have an additional income tax bill if your gains push your income over the higher or additional rate tax threshold in the year they mature.

Top slicing

However, you may be able to avoid this by using a method known as ‘top slicing’.

Top slicing works by dividing your profit over the lifetime of your bond (including withdrawals) by the number of years the bond has been held. If the resulting figure, when added to your other income for the tax year, is below the higher-rate tax threshold, there is no extra tax to pay.

However, if the top-sliced profits still push you over the higher rate tax threshold for the year, then additional tax must be paid on the entire gain.

How investment bonds compare

Gains from other types of investment, such as unit trusts, are subject to capital gains tax. Capital gains can be offset against your personal capital gains tax allowance, which is £11,100 in 2015-16. 

Even if you do make a gain that is beyond this, you will still only pay tax at 18% if you are a basic rate taxpayer – less than the 20% deducted automatically from an investment bond. 

Capital gains tax can also be given the swerve if you buy your investments in a Stocks and shares Isa

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Last updated:

March 2016

Updated by:

Michael Trudeau


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