Life assurance bonds can keep the taxman at bay

The taxman is always keen to take his share of everything, from your income to the wealth you leave your family, so finding ways to reduce your tax bill is a rewarding activity. The tax-planning opportunities available with life assurance bonds make them an appealing investment proposition.

"Life assurance bonds let you manage your tax liability in legitimate ways," says Ian Porter, head of wealth management at Alexander Forbes Consultants and Actuaries. "With HM Treasury becoming increasingly aggressive, they will become more and more popular."

Tax treatment

Life assurance bonds - which are also known as investment bonds, distribution bonds and with-profits bonds - benefit from a unique tax position.

Bob Perkins, technical manager at Origen Financial Services, says: "If you hold a life assurance bond, the life company will pay corporation tax at 20% on any gains made in the fund, which is broadly in line with basic-rate tax. But the rate deducted is often lower than this, sometimes substantially, because of the way it is calculated. There may be additional tax to pay, but this is deferred until the bond is cashed in and assessed on your tax status at that point."

Another unusual feature of a life assurance bond is that investors can withdraw 5% of the original investment every year, for up to 20 years, without incurring an immediate tax charge. Sarah Lord, managing director at Killik Chartered Financial Planners, says: "Because there's no immediate tax liability, this works well for people looking to supplement their income in retirement from a capital lump sum."

There's also some flexibility with these 5% tax-deferred withdrawals: you can defer them for as long as you like. For example, if you took out a bond while you were working and didn't need to take income from it until you retired in five years' time, you could either take a tax-deferred lump sum of 30% of the original investments in the sixth year or increase the amount you took each year to make up the difference.

Tax on gains

When you come to cash in your bond, your gain will be subject to income tax rather than capital gains tax. Investors receive an effective tax credit of 20% for the tax the life company has already paid. This means most basic-rate taxpayers will have no further tax to pay, while higher- and additional-rate taxpayers will need to pay a further 20% and 30% respectively on the gain.

If the profit on the bond pushes you from the basic-rate tax band into the higher-rate band, a technique known as top slicing is used to assess whether you have any further liability. Your liability will depend on the size of the gain and the length of time you've held the bond.

As an example, if you invested £100,000 and after 10 years it had grown to £120,000, the gain, of £20,000, would be divided by 10. This £2,000 would then be added to the taxable income you received that year. If this keeps you within the basic-rate tax band, there's no further tax to pay, but if it pushes you up into the higher or additional rates, you'll be subject to a further 20% or 30% respectively on the total gain.

Perkins says: "Most investors will delay cashing in the bond until they are a basic-rate taxpayer so that there's no further tax to pay, but if you're close to the top of the basic-rate tax band, top slicing may enable you to avoid paying any more tax on the gain.'

Offshore bonds

Offshore bonds are also available. These are provided by life assurance companies based in an offshore jurisdiction such as the Isle of Man or Dublin. They have exactly the same characteristics as onshore bonds but benefit from gross roll-up.

This means no tax taken off the income generated by your investments, other than the 10% tax credit on UK dividends that cannot be reclaimed, so your money grows faster. However, when you come to surrender the bond, you will pay tax at your marginal rate on any gain.

Nick Crabbe, director and wealth manager at Manse Capital, says this tax position means offshore bonds can be a good option if you're planning to move abroad before you surrender the bond, but he doesn't recommend them for other investors.

"They tend to be more expensive than onshore bonds," he says. "Over time, the benefits of gross roll-up might offset these higher charges, but I wouldn't recommend them unless you were moving abroad."

Wide berth

While Crabbe isn't keen on the offshore variety, some advisers give all life insurance bonds a wide berth. Arthur Childs, managing director at Arch Financial Planning, says he moves his clients out of these products on a fairly regular basis.

"Since capital gains tax came down to 18%, collective investments such as unit trusts and open-ended investment companies have had the upper hand," he explains. "They're more transparent and you don't have to worry about your future tax position."

The tax position on collective investments can also give investors greater flexibility. With unit trusts and other collectives, basic-rate taxpayers pay 18% on capital gains, but only after they have used their annual capital gains tax exemption (£10,600 for the 2012/13 tax year).

Given all the different taxes that come into play, Perkins says it's not always easy to work out which is best, as this will depend on the underlying investment and how and when profits are taken.

"If you're using a collective to invest for growth rather than income, you only pay 18% capital gains tax or 28% if you're a higher-rate taxpayer," he says. "And, if you use your annual exemption, careful planning means you can avoid paying this altogether."

Investing in income-producing assets does swing the tax argument more in favour of life assurance bonds because of the way life company funds are taxed. This advantage is heightened where the bond holder is able to postpone cashing in their investment until they're a basic-rate taxpayer, as they will have no further tax liability.

One gripe often levelled against life assurance bonds is their cost. Crabbe says one reason bonds have sold so well is the commission paid to the financial advisers who sell them. "Advisers have been able to get up to 7% commission on life assurance bonds," he says. "This won't be possible when the Retail Distribution Review comes into force, but it has influenced sales."

Future sales

Without a commission sway, the tax position and unique features of life assurance bonds are likely to be more considered when structuring investments. Perkins says they will remain a popular option for inheritance tax planning. "They're popular with discretionary trusts, as they can be structured so they don't distribute an income. This means you don't have the hassle, and expense, of filing tax returns on the trust," he explains.

Porter believes the bonds also have a place outside inheritance tax planning. "If you've used up your ISA allowances and you've got some spare money to invest, most investors would be no worse off investing in a life assurance bond," he says. "Additionally, depending on your circumstances, they can give you more tax planning flexibility."

PRODUCT COMPARISON

Onshore life assurance bonds

• Life company funds are subject to corporation tax at 20%, although in practice life companies pay less than this.
• A 5% withdrawal of original investment is allowed each year, with tax deferred until the bond is cashed in.
• Gains are taxed as income, and tax already paid is taken into account. This means basic-rate taxpayers have no further liability, while higher-rate taxpayers pay a further 20 or 30%.

Offshore life assurance bonds

• These offer gross roll-up, as no tax is deducted other than the 10% tax credit on UK dividends.
• A 5% withdrawal of original investment is allowed each year, with tax deferred until the bond is cashed in.
• Gains are taxed as income. Basic-rate taxpayers pay 20% and higher-rate taxpayers 40%.

Collective investments

• After allowing for the 10% tax credit, dividends are taxed at a further 10% at the basic rate, 32.5% at the higher-rate, and 42.5 at the additional rate.
• Gains are subject to capital gains tax, payable at 18% (28% for higher-rate and additional rate taxpayers) once gains exceed the annual CGT exemption level.

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