Onshore Investments

Tax inside the bond

The insurer pays tax on the income and gains within the fund at a rate broadly equivalent to basic rate. You pay no income tax or capital gains tax on the bond year to year, and there is nothing to report on a tax return while you leave it alone. The trade off is that this internal tax cannot be reclaimed, so a non taxpayer does not get it back.

The 5% rule

Each policy year you can withdraw up to 5% of the amount you originally paid in without an immediate tax charge. The entitlement is cumulative, so if you take nothing for four years you can take 20% in the fifth, and it runs until you have withdrawn 100% of the original premium. This is deferral, not exemption. Those withdrawals are added back into the calculation when the bond is finally cashed in.

Chargeable events

Tax falls due on what the rules call a chargeable event. That usually means surrendering the bond in full, withdrawing more than the cumulative 5% entitlement, the death of the last life assured, or assigning the policy for money. The gain is treated as income rather than as a capital gain, and because basic rate is treated as already paid inside the fund, a basic rate taxpayer who remains a basic rate taxpayer after the gain is added often has nothing further to pay.

Top slicing relief

A gain built up over many years arrives in a single tax year, which can push you into a higher band for that year alone. Top slicing relief spreads the gain across the number of years the bond has been held for the purpose of working out the higher rate liability. The calculation is fiddly and the order in which your income is taxed affects the answer, which is why the timing of a surrender matters as much as the decision to surrender.

A bond is normally issued as a large number of identical small policies, called segments. Instead of taking a partial withdrawal spread across the whole bond, you can surrender whole segments. The two routes are taxed on different bases and one is frequently far better than the other for a given set of circumstances. Choosing the wrong one is among the more common and more expensive mistakes made with bonds, and it is usually irreversible once done.

Because a bond is a policy rather than a pot of shares, it can be assigned to someone else as a gift without the assignment itself creating a tax charge. Assign it to an adult child at university, or to a spouse who pays a lower rate, and the eventual gain is taxed on them rather than on you.

Bonds also sit comfortably inside trusts, which is why they turn up so often in inheritance tax planning. A discounted gift trust or a loan trust is usually built around one. That is a conversation about your whole estate rather than about a product on its own, and it needs to come in that order.

It can be worth considering in a few situations.

• You pay higher rate tax now but expect to pay basic rate when you eventually draw on the money.
• You have used your ISA allowance for the year and want another sheltered home for capital.
• You are managing a figure that depends on taxable income, such as the personal allowance taper or the high income child benefit charge. A bond produces no income to declare until a chargeable event happens, so it does not add to your taxable income in the meantime.
• You want to hold an investment inside a trust without the annual reporting that other assets bring.

It suits less well if you would otherwise have a capital gains exemption and a dividend allowance going unused each year, because a bond gives both of those up. Charges need looking at properly too, since a bond carries a product charge on top of the underlying fund costs.

Bonds are one of the areas where advice earns its keep, less in the choice of insurer and more in when and how money comes back out. Heritage is a family run firm based in Taunton, advising clients across Somerset and the South West since 2000, and we are directly authorised by the Financial Conduct Authority under firm reference 624976. If you already hold a bond, whether we arranged it or not, we are happy to look at how best to draw on it.