Technical: 9 reasons to use bonds in financial planning
26 June 2018
Helen O’Hagan, technical manager Prudential, looks at why clients might choose a bond as part of their investment portfolio and strategy.
Bonds are subject to a unique regime called the chargeable event regime under ITTOIA 2005 (income tax (trading and other income) Act 2005). Chargeable events are triggered by the following events –
• Death of the last of the lives assured
• Assignment for money of monies worth
• Maturity of a capital redemption bond
• Encashment above the 5% cumulative allowance or
• Surrender of the segments or full bond
They are subject to income tax in the hands of individuals and trustees.
1. Unique 5% Rule
One of the unique features is the ability to take up to 5% of each premium in each policy year which is not assessable for tax at the moment. These 5%s can be used to live off or can be rolled up for future use. Let’s take a look at an example –
Helen invests £1m into a bond:
Here is an example which demonstrates that clients can take out up to 5% tax deferred – no tax, nothing to declare on the tax return at the moment. Also, the 5%’s roll up therefore Helen need not take any regular withdrawals until year 20, if she so wishes, and then take out £1m without triggering a tax charge.
This is advantageous for clients who are trying to limit their income tax liability each year. Thus in the example above, Helen can take £50k each policy year for 20 years without having to pay tax on the withdrawal at the moment. HMRC deem this as a return of capital thus it is only when a chargeable event occurs that an individual will be assessed for income tax.
Remember bonds are not normally subject to Capital Gains Tax (CGT).
Don’t forget these are tax deferred NOT tax free. The allowances roll up if not taken and can be used at a future date if needed. The bond is tested at the end of each policy year to see if the 5% has been breached. Every time the bond is topped up another 5% becomes available from the policy year in which the new premium is paid, in conjunction with the existing allowance.
2. Assignments between spouses
Bonds are normally made up of segments typically between 20 and 100 and they can be very useful tools in planning who pays the tax. Consider a client situation where you have a husband and wife who jointly own a bond. If that bond is surrendered when in joint ownership then normally the gain is split 50-50 between the owners of the plan. It may be of course that one spouse is higher rate and the other is a basic or nil taxpayer. Consider however the situation where the bond is assigned outright to the lower taxpayer. If that person subsequently decides to encash then that person will be the sole taxable person. The assignment should be a ‘no strings attached’ gift.
3. Assignment to beneficiaries
A similar position arises where there is a trust involved, as long as the beneficiary is over age 18 and a beneficiary of the trust, the trustees can assign segments as a distribution from the trust fund. This allows the beneficiary to choose whether to keep or surrender the segments. Should the beneficiary choose to surrender the segments. they are assessed for tax as if the beneficiary had owned the segment from inception and can benefit from top-slicing to help reduce any liability.
4. Excess events are not always bad
Normally when we talk about excess events it’s never good news! It normally happens when a client takes out a large withdrawal across all the segments and triggers an artificial gain. But let’s consider your clients who are non or basic rate taxpayers perhaps they can afford to take out more than the 5% s each month and trigger an excess gain. If we look at an example –Jack has been retired for several years he is a basic rate tax payer and he bought a UK bond in 2015 for £65,000. He took out a partial withdrawal £21,000 in 2016. He now wants to surrender all of the bond:
When Jack withdrew the £21,000 he received an excess event certificate for £14,500 at the end of that policy year. When this was added to his income for 2017/18 it did not take him into the higher rate tax bracket thus there was no further tax to pay.
So, let’s look at what happened when he did surrender his bond if we assume the surrender value is £58,600.
5. Bonds are non- income producing
As bonds are non- income producing assets there is nothing to report to HMRC until a chargeable event occurs. This means they can be very useful investments especially for trustees and individuals who do not normally need to complete a tax return. If you think about trustees of discretionary trusts, you can see they can be especially useful, not only by mitigating the trustee rate of tax by segments assignment, but also a tax return is not needed each year if the only asset the trustees hold is a life assurance bond.
6. Inheritance tax planning
Trusts may be used by your clients who want to do Inheritance Tax Planning (IHT) and retain control over their gift. There are two types commonly available which are Absolute trusts and Discretionary trusts. Absolute trusts are normally used for minor children due to the fact that on reaching age 18 (16 if written under Scot’s law) the beneficiary is entitled to the trust fund. Discretionary trusts offer the most flexibility for the trustees.
Clients may not be quite ready to pass the asset outright to their beneficiaries. Bonds are widely used in a range of IHT effective trusts i.e. gift, loan and DGT’s. They are used because of the 5% feature which is used to supplement many individuals income requirements, for tax efficiency due to the chargeable event regime and the fact that it’s only when an event occurs that there is a potential tax liability. They are also very flexible as they are normally issued with a number of segments that can help with tax efficiency. Trustees are able to assign segments to beneficiaries who can then surrender and be assessed at their own marginal rate rather than the trustee rate of tax which is 45%.
7. University Fees
Moving onto school fees planning, bonds can be especially tax efficient in these circumstances. The efficient use of bonds to combine IHT planning whilst helping children or grandchildren with cost of university can be attractive to clients.
If we look at an offshore bond for example, it will grow in a virtually tax free environment and it is normally made up of 100 individual segments.
An offshore capital redemption bond will ensure longevity and give the trustees the choice of who eventually pays any tax on the chargeable gain. The trustees can make use of segment assignment to ensure the best tax result can be achieved for the beneficiary.
Insurance companies typically offer many different types of trust for IHT planning including absolute and discretionary versions.
8. Choice of offshore and onshore
For a client contemplating an onshore or an offshore bond here is a list of differing attributes –
1.The bond will grow in a gross environment with little or no tax dragging on the fund
2.The longer it stays invested, the longer the gross roll up applies
As you can see there are no hard and fast rules about whether investors should invest offshore or onshore. To a large extent, it is very much down to length of time of the investment and the tax status of who is going to eventually be liable for the tax when a gain occurs.
Companies are either classed as micro entities which are taxed under the historic cost basis or all other companies who are taxed under the fair value basis.
Under the historic cost basis, the premium paid for the bond is held in the balance sheet and basically the company defers any corporation tax until monies are taken out. If it is an onshore bond the basic rate tax deemed paid within the fund satisfies the corporation tax liability.
Under the fair value system, the surrender value of the bond is assessed at the start of the company year and at the end of the company year, the difference each year will be classed as a non-trading profit or loss and the appropriate tax paid. This means that for onshore bonds when the company eventually takes money out of the bond, as basic rate tax has been deemed paid within the fund the company with get a tax credit for the tax paid. Companies may see investing in a bond as an alternative to keeping their cash in banks or building societies due to their poor rates of return.
I hope this article has demonstrated that there are many reasons why clients may choose a bond as part of their investment portfolio and strategy.
They have a useful facility where you can take up to 5% of the original investment in each policy year whilst deferring the tax. This 5% can roll up and be used at a future date by your clients.
Bonds are classed as non- income producing assets which are segmented to allow for flexibility in who eventually pays the tax. You can find more information on the taxation of bonds if you click on the links below –