At your ISA limit? Why old-school Investment Bonds could be your next tax-efficient investment

Alongside pensions, ISAs are the most tax-efficient ways to invest our money. We don’t pay Income Tax or Capital Gains Tax on growth, returns or interest and can invest up to £20,000 every year. Not surprisingly, they’re popular. Between 2021 and 2022, we subscribed to 11.8 million adult ISA accounts[i].

And now ISAs are more user-friendly than ever. From April 2024, we can open multiple Cash ISAs or Stocks and Shares ISAs in the same year rather than being limited to opening one of each type. This means we can spread our investments, take advantage of deals and benefit from both the higher rates that come with locking our money away and the convenience of keeping some in ‘easy access’ ISA accounts.

However, if you’re lucky to have more than £20,000 to invest you need other tax-efficient options.

This is where Investment Bonds – also known as guaranteed equity bonds or insurance bonds – can be useful additions to your investment portfolio.

What are investment bonds?

Investment Bonds are single life insurance policies wrapped around an investment account, like an ISA. They are a lump sum investment that can continue until you die (or beyond). They also have significant tax advantages and can be accessed whenever. However, to be tax efficient there are limits to withdrawals (I’ll explain shortly).

Investment Bonds can grow your investment over the medium to long-term, ideally over a minimum of five to 10 years.

And in addition to savings growth, the life insurance element adds to the ‘pot.’ So, if the life insurance element is worth 1% of your investment and your investment is worth £75,000 you’ll get an additional £750 added to your investment when you pass away, benefitting your named beneficiaries.

Why are investment bonds tax-efficient?

Your income and investment portfolio can complicate how much tax you pay and on what, but Investment Bonds do follow some basic principles for tax-efficient planning:

1. Investment Bonds do not generate an income. Any growth of the investment simply increases the Bonds’ value.
2. You can withdraw 5% of your original investment value each year with no immediate tax implications. So, if your investment is £100,000 you can take out £5000 each year. If you don’t withdraw any until year four, you can take out 20%.
3. Basic rate tax (20%) is paid by the investment company, so you won’t feel the impact of this.
4. Investment Bonds are not subject to Capital Gains Tax.
5. You will be eligible to pay income tax on your investment bonds if a ‘chargeable event’ occurs. This could be taking out more than the 5% investment, cashing in on all or some of the bonds and your death, or those of any named beneficiaries. However, whether tax needs to be paid, depends on factors such as your other income, whether you’ve made previous withdrawals and whether you’ve used up all your personal savings allowance.

Who are Investment Bonds best for?

Whether an Investment Bond is a worthwhile option for you will depend on your individual circumstances. However, they are more likely to suit you if:

1. You have income you want to invest tax-efficiently over and above your yearly ISA allowance of £20,000.
2. You’re a higher rate tax payer and envisage becoming a basic rate taxpayer in future, e.g. you’re planning for an investment that will add to your pension income.
3. You want to gift a regular amount or lump sum to your children or grandchildren
4. You want to reduce potential future inheritance tax on your estate.
5. You want to invest without the bother of yearly tax returns. With Investment Bonds no income is generated until they’re cashed in.

Understanding Investment Bonds

As with all things financial, scenarios can help you understand whether Investment Bonds are a worthwhile option for you.

Investment Bonds Scenario 1 – You’re a  higher rate tax payer

Simon has made £30,000 on his bonds over 10 years. He invested £40,000 and now has £70,000. His salary is £49,270. He hasn’t withdrawn anything from his Investment Bonds but now wants this £30,000.

Adding this £30,000 it to his income would push him well into the higher rate tax bracket (40%). However, his investment gain is subject to ‘top slice relief’. This is calculated by dividing his gain by the years he has held the investment bonds: £30,000 divided by 10 = £3,000. Adding this £3000 to his salary pushes him £2,000 beyond the higher rate tax threshold (which currently stands at £50,270).  Multiply £2,000 by 10 years (the length of the investment) and this £20,000 is considered the ‘chargeable event.’ It is the total amount eligible for tax. However, it will only be taxed at 20%, the difference between basic rate and higher rate tax.

Investment Bonds Scenario 2 – You’re a  basic rate tax payer

Claire has made £15,000 on her Investment Bonds. She invested £20,000 10 years ago and it’s now worth £35,000.  Claire retired last year and has an income of £21,000 from her company pension. The £15,000 added to £21,000 equals a yearly income of £36,000, which is still below the higher rate tax threshold (£50,270), so she has no additional tax to pay.

Investment Bonds Scenario 3 – Investing for grandchildren

Peter invests £20,000 in an International Investment Bond (already set up by Parent or Guardian) for his newborn granddaughter Beatrice to help her through university. He puts it in trust for her to access when she’s 18.

For 18 years the money grows tax-free (Investment companies don’t have to pay tax on International Investment Bonds). The initial investment has grown by £15,000 to £35,000.

Beatrice can now choose to take out a regular amount (5% of the investment or below) or cash in some or all the Bonds.

If Beatrice doesn’t have any other income at the time she cashes in the Bonds she will be able to offset any tax due against her personal tax allowance (£12,750), potentially her Starting Savings Allowance (£5,000) and the Basic Rate Savings Allowance (£1,000). This means she can take out up to £18,570 a year tax-free.

The value of an investment with St. James's Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up.  You may get back less than you invested.

The levels and bases of taxation, and reliefs from taxation, can change at any time.  The value of any tax relief is generally dependent on individual circumstances.

Please note that if the withdrawals taken exceed the growth of the Bond, the capital will be eroded.

Investment bonds can be complex, but I can help you determine whether they are a worthwhile investment for you and your circumstances.  Contact me today for a non-obligation meeting. And if you want more tips on managing your money better, take a look at my other financial planning articles.

[i] UK Government Website – June 2023 Statistic on UK ISA

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