The smart way to reduce your tax bill
The taxman is always keen to take his share of everything, from your salary to the wealth you leave your family, so finding ways to reduce your tax bill is rewarding. 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 & Actuaries. "With HM Revenue & Customs becoming increasingly aggressive, they will become more popular."
Life assurance bonds - also known as investment bonds, distribution bonds and with-profits bonds - are investments purchased with a single payment where your money is paid into an asset-backed fund.
You then receive interest on your investment and at the end of a set period you'll get your money back plus any gains, or you could lose money if the assets don't perform well.
The main attraction of the bonds is that they benefit from a unique tax position. While you hold a bond, you don't pay any tax yourself. Instead, the life company pays corporation tax at 20% on any gains made within the fund.
"This is broadly in line with basic-rate tax but, because of the way it's calculated, many life companies pay a lower rate of corporation tax, which could help your investment grow faster," says Bob Perkins, technical manager at Origen Financial Services.
When you cash in the bond there may be more tax to pay but any liability is assessed on your tax status at this point. So, if you're a higher-rate taxpayer and you don't cash in the bond until you retire, when you may well be a basic-rate taxpayer, you could make significant savings.
Another unusual feature of a life assurance bond is 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: "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 taxdeferred 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.
When you come to cash in your bond, your gain will be subject to income tax rather than capital gains tax (CGT). Investors also receive an effective tax credit of 20% for the corporation tax the life company has already paid on the gains.
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 into the higher-rate tax band, a technique known as 'top slicing' is used to assess what tax you have to pay. It depends on how much you've made and how long you've had the bond.
However, some advisers give life assurance 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 CGT 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 these investments, basic-rate taxpayers pay 18% on capital gains, but only after they have used their annual CGT allowance (£10,600 for the 2012/13 tax year).
Given all the different taxes, Perkins says it's not always easy to work out whether a collective investment or an investment bond is best, as this will depend on the underlying assets and how and when profits are taken.
"If you're using a collective to invest for growth rather than income, you only pay 18% CGT 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 if you are able to postpone cashing in your investment until you're a basic-rate taxpayer, as you will then 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 [when advisers can no longer take commission], but it has influenced 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 favoured 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 of filing tax returns on the trust," he explains. Porter believes the bonds also have a place outside IHT 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 taxplanning flexibility."
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.
Generally thought of as being interchangeable with insurance but isn’t. Assurance is cover for events that WILL happen but at an unspecified point in the future (such as retirement and death) and insurance covers events that MAY happen (such as fire, theft and accidents). Therefore you buy life assurance (you will die, but don’t know when) and car insurance (you may have an accident). Assurance policies are for a fixed term, with a fixed payout, and unlike life insurance have an investment aspect: as a life assurance policy increases in value, the bonuses attached to it build up. If you die during the fixed term, the policy pays out the sum assured. However, if you survive to the end of the policy, you then get the annual bonuses plus a terminal bonus.
Issued by life companies and designed to produce medium- to long-term capital growth, but can also be used to pay income. The minimum investment is typically £5,000 or £10,000 and your money is invested in the life company’s investment funds, so the bond can either be unit-linked or with-profits. They offer a number of tax advantages, such as the ability to withdraw up to 5% of the original investment amount each year without any immediate income tax liability. Also, a number of charges and fees apply, such as allocation rates, initial charges, annual charges and cash-in charges. As investment bonds are technically single-premium life insurance policies, they also include a small amount of life assurance and, on death, will pay out slightly more than the value of the fund.