Investment Bonds, insurance company based investment arrangements, higher rate taxpayers

Unit-linked bonds are collective investment funds similar to unit trusts. The difference is that they are run by insurance companies. Like unit trusts their value can fluctuate from day-to-day, making them riskier than with-profits bonds - see below.

What is the tax treatment?
For tax purposes unit linked bonds are treated as if basic-rate tax has already been deducted. This can make them unsuitable for non-taxpayers or 10 per cent tax-payers, since the tax cannot be reclaimed.

Basic-rate taxpayers have no more tax to pay, unless gains push them into the higher rate band in the year they cash the bond in. Investors can draw out up to 5 per cent each year, for up to 20 years, with any potential tax liability deferred until encashment.

If you can time this for a year when your income falls back to the basic-rate level, perhaps when you retire, you will also have no more to pay.

There is no CGT liability on an insurance bond, and if you sell the investment when you are still paying the top rate of income tax, the "top slicing" rule means your return is divided by the number of years you've held the bond - giving a much smaller tax liability.

Their tax status can make unit-linked bonds attractive for higher-rate taxpayers when compared to direct unit trust and OEIC investments, but not when compared to the greater tax-breaks on offer from a unit trust or OEIC held in an ISA.

The risks of investing in unit-linked bonds are similar to those for unit trusts, and will depend on the type of fund you select. There are hundreds of funds to choose from, in a couple of dozen different sectors, including UK Equity Income, Property, North American, UK Fixed Interest and Far East Including Japan.

With Profits Bonds
With Profits funds aim to achieve a reasonable return without you having to invest directly into the stock market where you may have to watch the value of your investment rise and fall in value day by day.

Although With Profits funds typically invest in shares, fixed interest securities (mainly Government Stock or Gilts), Property and Cash, providers smooth out fluctuations in the underlying investment values by adding bonuses each year.

How are bonuses added to my With Profits Bonds?
What makes With Profit funds attractive to some is the way your money grows. Every year the life company will assess it's profitability, investment returns, and what it thinks the future holds.

If after taking into account these factors, things look favourable, the company will announce an annual bonus rate (known as a reversionary bonus) that will be added to your plan increasing its value year after year. Any annual bonuses applied are then guaranteed by being 'locked on'.

In general, providers will declare a conservative annual bonus because the underlying investments will continue to change in value.

In addition, if any money is taken from the bond, for example if the bond is cashed in or if the bondholder dies, the provider will usually add a further bonus. This is called the terminal bonus. The terminal bonus is designed to make sure that you receive your share of the growth achieved from the with profits fund over the period that you have been invested.

How much "income" can I take from an investment bond?
Under current legislation, up to 5% of the amount you invest can be withdrawn net of basic rate income tax each year. These withdrawals are treated as being taken from your capital.

Most investment bonds allow you to take a regular income monthly, quarterly, half yearly or annually.

You can normally choose to take an income immediately, or you can wait until later.

There is no immediate tax charge, and so long as you are all remain a basic rate taxpayer, then no income tax charge will apply. There may be additional tax to pay if you are or become a higher rate taxpayer.

How can investment bonds help with my tax planning?
You will have no personal liability to basic rate income tax or capital gains tax on the returns you receive because investment bond providers pay the equivalent of these taxes within the fund.

This cannot be reclaimed if you are a lower rate or non-tax payer.

You may have to pay further tax in the following circumstances;

You are a higher rate taxpayer when you cash in all or part of your bond, die, or assign the bond for money or moneys worth
The growth from your bond makes you a higher rate taxpayer when you cash in all or part of your bond
You take regular withdrawals of more than 5% of the amount you invested and, including this income, you are a higher rate taxpayer.
You encash a bond when you are over 65 and the gain, when added to your income, affects any age related tax allowances that you may be in entitled to.