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A Guide to Lump Sum investments

 

Investment bonds

Investment bonds are single premium life insurance policies which allow you to invest in a variety of funds managed by professional fund managers. They will include a small amount of life cover (often just 101% of the amount invested).

Bonds can be particularly attractive in the following 3 situations: -

1) If you are retired and require an additional, supplementary income, but you are in danger of falling into the age allowance ‘trap’.

2) If you are an active investor with a large direct investment portfolio who has already used their annual capital gains tax allowance (£10,600 in 2012-13, rising to £10,900 for 2013-14, £11,000 for 2014-15 and £11,100 for 2015-16.)

3) If you are an investor who is likely to need long term care at some point in the future.

These are explained in more detail below after the basics of investment bonds have been explained.

The minimum investment amount varies by provider, but is generally around £5,000 or £10,000. When you make an investment, you will be allocated a certain number of units in the fund or funds that you are investing in. Each fund will hold a range of investments, such as equities, property bonds and cash; and the price of your units (i.e. the value of your investment) will therefore rise or fall in line with the value of these investments held within the fund(s).

Initially Investment Bonds were all ‘unit linked’ but during the 1990s, ‘with profit’ bonds became very popular. Just like managed funds previously described, with profit funds invest in a spread of assets, but the way that the investor participates in the investment performance differs significantly.

Investment returns on with profit funds are obtained by bonuses declared by the insurance company that offers the with profit bond. The aim of ‘with profits’ was to smooth out the returns by awarding annual ‘bonuses’ so that investors did not suffer from the same fluctuations as from investing directly in the stock market. However, following the stock market turmoil experienced over the last decade, many insurance companies have had to cut their bonuses dramatically (and in some cases even completely). As a result, large numbers of Investors lost money and consequently with profits bonds became much less popular.

Investment bonds are now however, far more diverse and they offer a much wider range of investment fund links. Previously, they often only offered funds managed by their own investment managers but due to competition and demand, many now offer funds managed by external fund managers.

As bonds are actually life assurance contracts, the assurance company will pay Corporation tax on the income and capital growth generated by the investments held in the bond. Consequently the investor does not pay any capital gains tax (CGT) on gains made by investing in the bond, nor do they pay any basic rate of income tax on any income that they draw from the bond.

However, if a bondholder is a higher rate taxpayer, they may become liable to income tax at their higher marginal rate (i.e. the rate equal to the difference between the basic rate and the higher rates) in the following circumstances:-

  • On the death of the policy holder;
  • On transfer of legal ownership of all or part of the bond (unless by assignment to a spouse/civil partner or adult child);
  • On maturity of the bond (unless the bond is written as a ‘whole of life’ policy in which case the bond will remain in force until surrendered or the life/lived assured dies);
  • On full encashment of the bond;
  • On withdrawals in excess of 5% of the original investment per policy year.

The 5% withdrawal allowance is cumulative, and so any unused allowance may be carried forward to future years, however the total cumulative 5% allowance amount can never exceed 100% of the amount originally invested in the bond.

Encashing your bond.

When you eventually encash your bond, if you have made a gain, this could potentially push you into a higher rate tax bracket, even if you were a basic rate taxpayer at the time of encashment. However, a facility known as ‘top-slicing relief’ can minimise this possibility.

Top slicing relief works like this; your total gain – the difference between your original investment amount and the final encashment value of the bond, plus the value of any withdrawals throughout the period that you held the bond – is divided by the number of full years that the bond was held, to calculate the average gain.

If this figure (the average gain), when added to your other income, still keeps you in the basic rate tax band, then you will have no further tax liability. If however, it puts you into a higher rate tax band, you will be charged higher rate tax on the proportion that falls within that higher band, multiplied by the number of years that the bond was held. If you are already a higher rate taxpayer in encashment of the bond, then you will have to pay extra tax on the whole gain.

However, there are ways that you could avoid paying this higher rate tax for example, by delaying the encashment of your bond until you are a basic rate taxpayer (say after retirement) or by gifting it to a spouse who pays less tax.

If you are a higher rate taxpayer seeking an extra income, an investment bond may be suitable for you because you are entitled to make up to 5% annual withdrawals, for twenty years or until the total withdrawals reach 100% of the original investment amount, without any immediate tax liability.

Bonds can also be particularly attractive in the following 3 situations: -

1) If you are retired and require an additional, supplementary income, but you are in danger of falling into the age allowance ‘trap’. This is the situation whereby the extra personal tax allowance you receive when you are 65-74 years old (£10,500 for 2012-2013) is reduced if your annual income exceeds a certain level (£25,400 for 2012-2013).

The reason that a Bond can be an attractive investment in these circumstances is that the annual 5% withdrawals from an investment bond do not count as ‘income’ and so they do not affect your age allowance. However, before you finally encash your bond, you will need to consider whether or not the encashment will affect your age allowance in the year of encashment.

2) Similarly, if you are an active investor with a large direct investment portfolio who has already used their annual capital gains tax allowance (£10,600 in 2012-13, rising to £10,900 in 2013-14, £11,000 in 2014-15, £11,100 in 2015-16), you could use an investment bond to ‘manage’ your investments, as you will not be liable for CGT when you switch between funds.

3) If you are an investor who is likely to need long term care at some point in the future. Life assurance policies are not normally counted as part of your assets (or means) when your eligibility for local authority funding is assessed.

What are their charges?

One of the problems with investment bonds is that their charges are not always easy to understand, and there is no ‘fixed’ charging policy.

Sometimes there can be initial charges of up to 5%, plus an annual management charge (AMC) of 1% to 1.5%. However, some bonds can have no initial charge, but have a much higher annual charge in the first three to five years.

Unit allocation rates are the percentage of your initial payment that actually goes into the investment. Some larger investments may have unit allocation rates of over 100%, however, do not be fooled into thinking the company is being generous, as higher unit allocation rates usually just offset the initial charge. For example, if you invest £100,000, a 5% initial charge will reduce your capital investment to £95,000, so if you receive an allocation of 102%, the amount actually invested will be £96,900.

Almost all investment bonds have early withdrawal penalties if you encash the bond during the first five years.

In the case of with profit bonds, some insurance companies also apply a ‘market value adjustment’ (MVAs) at times of market volatility, which will reduce the value of the investment, although some insurers allow you to encash bonds on each 10 year anniversary, without applying an MVA.

NEXT STEPS

To learn about other investment options, return to the Introduction to investments section.

To learn about the following investments, if you aren't already familiar with them click on the relevant link:

However if you feel that you need some help from a financial advisor, then visit our section on obtaining financial advice, or our page on Laterlife selected services and associated advice.

 

 

   
 
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