In this blog, I will look at “What is a Bond?”
A Bond is just like any other form of investment. All investments whether it be a NISA, a pension, a bond, or a general investment account, all work in much the same way apart from their tax status. This is why they are often called “tax wrappers”.
Whatever tax wrapper you put your money into, it will be “invested” in much the same places whether it be cash, government or company loans, commercial property, or company shares. Your money will be “pooled” with other investors’ into funds that hold a mixture of these “assets” based on your attitude to risk, term of investment, and a number of other factors.
A Bond is often utilised where other allowances – such as the pension’s annual allowance and the ISA allowance have been used. It does not provide tax relief but there are very few restrictions – there is no restriction on the amount you can invest (although some providers may have a minimum amount that can be invested) or the amount you can withdraw, although withdrawals may be subject to tax.
There are 2 types of bonds – offshore and onshore. The main difference between these is how they are taxed.
Onshore vs Offshore
The taxation of Onshore Bonds is very complex. Simplistically, within an onshore bond, the funds have tax deducted at 20% on gains whereas, within an Offshore Bond, this tax deduction does not apply (gross roll-up is used). This, therefore, means that Offshore Bonds will increase in value at a greater rate than an onshore bond all things being equal.
For example, if 2 people invested £100,000 – one into an onshore bond and the other into an offshore bond at exactly the same time, in the same fund with the same charges, based upon 3% growth per annum, after 20 years, the Onshore Bond would be valued at £160,693.80 and the Offshore Bond would be valued at £180,611.12 a difference of £19,917.32.
When an onshore bond is then encashed, a basic rate taxpayer would have no further tax to pay unless the encashment pushes them into higher rate tax, and then they may have an additional 20% to pay.
Withdrawals and surrenders
Withdrawals from both Onshore and Offshore Bonds are tax-deferred. This means that 5% of the original investment can be withdrawn annually without any tax to pay until the bond is encashed. So for example, if a client invested £100,000 into a bond, they could take out £5,000 each year for 20 years without having to pay any tax at the time of the withdrawal. If a 5% withdrawal hasn’t been used in previous years, this can be carried forward e.g. if a client has held a bond for 2 years and didn’t take 5% in the previous year, they could take 10% tax deferred this year.
Bonds are split into ‘segments’, which means that depending on what is best for the client’s circumstances, they can either encash whole segments or take a withdrawal across each segment. This will impact the tax the client has to pay – if the encashment is above the 5% capital repayment.
When a bond is surrendered or a “chargeable event” occurs if the gain takes the client into a higher rate or additional rate tax, the gain can be divided by the number of years the bond has been held and that amount would be added to the client’s taxable income rather than the whole gain to establish the rate of tax that will be paid on the gain. This is called “Top Slicing”.
For offshore bonds, top-slicing can be taken back to the inception of the bond.
Bonds are deemed to be “savings” and therefore qualify for the savings tax exemption (not applicable to additional rate taxpayers) as well as the £5,000 savings band for low earners and can also be offset against the personal allowance.
Bonds are often used as investment vehicles within Trusts.
If you would like to review your financial plans, contact me for a complimentary, no-obligation initial meeting.