148- Investment Bonds Explained, Does Your Financial Plan Need One?

In this episode of Headsup on Money, Benjamin explains the pros and cons of investment bonds. They can appear very confusing, and you are probably unsure whether or not your financial plan needs one. But by the end of this episode, you'll have mastered the pros, the cons and be more confident about whether they could help you save tax. 

Jargon-free as always. 

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Disclaimer - please note that nothing in this podcast can be relied upon as financial advice and the content is provided purely for information and guidance purposes. Please seek independent, regulated financial advice relevant to your situation.

Transcript

0:10

Hello money nerds, welcome to episode 148 of Heads Up on Money. Hope we're all well on this personal finance Friday. As I'm recording this today, a couple of days ahead of release date, staring out at a very dreary Edinburgh. I feel like we've not long passed the bank holiday and suddenly it was tapsaff weather in Scotland, and all of a sudden we seem to have regressed back to rainy winter, but that's what makes us British. What else would we talk about if we didn't talk about the weather? Aside from the fun of running a regulated financial advice business, personal life at the moment has been pretty busy for myself and my wife Hannah is we've not long earlier in the year we moved house and it's some project stuff going on in the house at the moment. Last week we had some of our floors were sanded. This is um funnily enough one of those things that we were naive thinking we could tackle ourselves. We thought we could do it ourselves, and in the end, quickly realised it was way beyond our skill set and our pay grade, so we got some professionals in. It turned out to be a fairly mammoth job lasting longer than a week, so as a result, we had to move out for a while. Myself Hannah and our cat Dusty, we relocated over to Portobello on the east coast of Edinburgh, where Hannah's auntie stays, and we stayed there for a week, which was great. Good opportunity for me to get on with some of the business stuff and do a bit of planning around the podcast as well, whilst there was chaos going on in our house. So it never rains, but it pours in more than one way, clearly, looking out of the weather today. So thank you as always for joining me, Money Nerds. A quick recap of what I covered last week. Um, looking at the data around the podcast, it was a very um well-received one, popular one on a different way to protect your family. So I outlined perhaps a way of ensuring your life for a more cost-efficient way. Often that many people who don't seek regulated financial advice perhaps aren't aware of this avenue. So listen back to that one if you want to understand a good way to protect your family without the full cost of perhaps life and critical illness cover, which I can appreciate. Whilst it's extremely important and would recommend it wholeheartedly where I can. The premiums sometimes can be fairly hefty, so listen back to last week's episode. Coming up today, it's a bit of a niche one, it's a technical one, but it's a really important one. I'm talking bond. James Bond, nope. Not talking even premium bonds, and I'm not even talking about bonds as an asset class being debt instruments. Why in financial services do we have to have not only confusing names for things, but names, in this case bond, that apply to so many different facets of personal finance. No, in this episode I'm talking about the investment bond. Some of you may have an investment bond, some of you may have heard of an investment bond. It's a bit more topical in personal finance news at the moment because of the capital gains tax exemption having gone down, and I'll come on to the intricacies of that later in the podcast, so stick around. But the actual technicalities and how an investment bond wrapper works is quite complex, and you should be you should be seeking regulated financial advice if you're getting into this area. That's the the short answer here. But trying to empower you to have this knowledge so you go armed into discussions with your advisor in the best possible way. I'm going to give you a bit of a heads up on money, classic overview of what investment bonds are, the pros, the cons, gonna try and be as impartial as I can be, so you can understand if they may or may not play a significant part in your financial plan. So I'm gonna break down what exactly is an investment bond. I'm going to go into the details of the different flavors of investment bonds, which primarily are onshore investment bonds and offshore investment bonds. I'm gonna go into why they can be confusing at first, and even when you get to understand the intricacies, even if you're in this personal finance space, even if you enjoy this jargon, they're still a complex product in comparison to the likes of ISAS pensions and even general investment accounts. So I'm gonna go into the pros, the cons, and then as I said, understand how it fits in with your financial planning, and finally, I might do a little bit of a section on where investment bonds do have relevance, and that is around trust planning, around things like mitigating your inheritance tax liability. So by the end of this episode, if you're still with me, then you should have a clear and practical understanding of when investment bond can be a smart tool in your armory and when you need to disregard it. So let's start with the basics. Bond, James Bond. No, it's an investment bond, but it's not a bond in the traditional sense as I alluded to at the start of the episode. We're not talking about bonds as in the other flavor of investing, typically bonds versus equities. We're not talking about premium bonds, the national savings and investments cash vehicles, which are arguably a good house for your short-term cash needs because they're backed by the government and you never know, you could win big in the premium bonds this month, you could be the lucky winner. We're not talking about either of those. Instead, we're talking about investment bonds being a tax wrapper. So we've gone into this metaphor before on the podcast is that an ISA and a pension and a general investment account, they're nothing but investment wrappers, boxes. Whatever you want to imagine it, all they are is a little container with which that container has its own intricacies and tax rules. And within each of these respective containers, what you hold within that container will be the assets within it. And it is the assets within it that will determine your growth potential. The higher you expose to equities, the greater short-term volatility, but the greater potential for long-term capital growth. Now, as I've said, each of these tax wrappers, they have their own rules. They have times in life when they are more appealing than others, and good financial planning, as often is a balancing act between a number of them, in such that you can try and be as flexible as you can, you can use the tax rules of the game that they each have to give you basically as much optionality and flexibility in the future. Case in point, if you were to aggressively fund pensions with a view to getting tax relief on the way in, that's great, but you're going to be restricted on the way out because beyond your tax-free lump sum, any income you take from a pension is taxable. So if in retirement you suddenly needed to get your hands on a significant amount of wealth from your pension and you had exhausted your lump sum, any residual amount you take could be subject to punitive tax rates. So in that instance, you may perhaps, you know, I'm just thinking out loud, this is not advice. You could take pension taxable income up to the higher rate band, and beyond that, take a withdrawal from your ISA. Or crystallize investment gains within your general investment account up to the capital gains tax exemption and take the remainder out of your general account. Having all these wrappers at your disposal does create flexibility in the future. And investment bonds can be thought of really as the fourth rung on that ladder. So they're quite complex, and I don't recommend them very often for clients because if you are in the realm of needing an investment bond, then by principle you should be as close to exhausting your pensions, your ISAs, your general accounts in every year. Now the reason why they've become slightly more in vogue again is because of the capital gains tax exemption. If we recall what a general investment account is, is a general investment account is the same as an ISA, it just gets a pretty crap deal from a tax perspective. So within a general investment account, any income that accrues within that general investment account, be that interest from bonds or cash or dividends from stocks, shares, will be subject to ongoing income tax. Similarly, if there's an appreciation in the value of your holdings, if there's capital growth, then that will be subject to what's called capital gains tax. And you pay capital gains tax at rates lower than income tax, but there's, if you read the news, strong potentially direction of travel here that there's going to be an alignment between capital gains tax rates and income tax rates. I don't have a crystal ball, I really wish I did at times, but it seems like that's a low-hanging fruit for governments to address some of the mess that we are in. Now the capital gains tax exemption, which can be thought of as your annual capital gains tax freebie, did sit much higher than it does at the moment, but it's come down over a number of years now where it's sitting at £3,000 per person per tax year. So if you're realizing a significant amount of capital gains in excess of that £3,000 level in any one tax year, you could be paying fairly punitive levels of capital gains tax. And capital gains tax rates sit within your wider income tax package. So if you're already earning a lot of money from perhaps employment income and you are, say, earning, let's say, £85,000 a year, then any capital gains you realize beyond your exempt amount will sit on top of that income. So you'll pay capital gains tax at the higher rate of capital gains tax. Because the capital gains tax exemption is so low now, you don't really need to have much in a general investment account for you to be busting these allowances. So that obviously brings in the rationale of using an investment bond. However, investment bonds are typically more complex, and sometimes complexity cannot be the answer. Tax mitigation, whilst it's an important driver, should not always be the driver. So if we go back to what is an investment bond, it's similar to a pension or an ISA in that it wraps around your investments. You could in theory hold the same portfolio within both your investment bond and your ISA and your pension and your general account. But the idea with an investment bond is you invest a lump sum, the money grows within the bond, and you can take withdrawals in a structured way if you want to, but tax is handled very differently in comparison to the more traditional forms of investing. We'll come back to that soon in the podcast. Now, as I said, there are two flavors of investment bonds. There are onshore and offshore bonds. It sounds like this is some weird tax dodge, and probably you think about offshore trust schemes and tons of stereotypes are coming to mind, but it's not as sexy as it sounds. It's pretty boring actually. There are two main types of investment bond. Onshore bonds, they're issued by UK insurers, and what this means is that basic rate tax, let's say 20%, is already paid within the fund by the insurer. So there's a 20% drag ongoing within that product because basic rate tax relief is already being paid on your behalf. So this means if you're a basic rate taxpayer, there's no extra tax for you to pay. If you're a higher or an additional rate taxpayer, let's keep this as simple as possible. I'm assuming tax ban south of the border, up here in Scotland, where we've got 127 tax bans, jest of course, but we've got a lot, it gets complicated. So let's keep it UK rates. Higher, additional rate, and of course the basic rate. So higher and additional rate taxpayers, they may have to pay more tax if they were to make a sizable withdrawal from the bond. So it's simple an onshore bond. It's often suitable for UK residents who are not going to have much difference in the way of how much they'll pay tax now and in the future. They may have a basic rate salary at the moment, and in retirement they're going to have a guaranteed pension income which will remain in the basic great band. So their tax position is broadly going to be the same throughout the rest of their life. An onshore bond may be applicable and suitable for them. Contrast this with an offshore bond. So these are placed in based in places, sorry, like Ireland, Luxembourg, Isle of Man I've seen, and the investments within an offshore bond grow largely tax-free within the actual bond wrapper itself. Because they're domiciled offshore, there's no UK tax being applied as the fund grows. So that analogy I went into with an onshore bond where there's almost like this 20% wind that is dragging you back, doesn't apply offshore. It rolls up gross with no taxes, which means it can accumulate fairly quickly. And this can be particularly more efficient for someone if you are a higher earner at the moment and you perhaps think you will drop your income later on in life, in retirement, for instance, or even if you were thinking about moving abroad in the future. And I'll come back to that reasoning as to why it's good if you're a higher earner now, later on. So this all sounds pretty good, but why are investment bonds not as mainstream as they appear? Well, one thing, of course, is the cost, they're quite an expensive product in comparison to ISA's pensions, and they're pretty confusing as well. So not many DIY investors would go near these. Often you need regulated financial advice to get this into your financial plan. But they can be beneficial in some cases. But the reason why they're confusing is around something called the 5% rule. So I'm going to give you very much the headline summary on this. Is when you invest money in an offshore or in an onshore bond, you can withdraw up to 5% per year of the original investment and it's not immediately taxed. It's treated as a return of capital. So let's say you put a hundred grand into a bond, then every year you're entitled to five percent of that back, no questions asked. So you get five grand back in year one, five grand back in year two, and that carries forward cumulatively. So if you hadn't used it for three years, you would have a cumulative allowance of 15 grand. And if you're doing your maths here, if I'm saying five percent a year, then over 20 years that means you would have the entire capital of the bond returned to you. Now, if you exceed that allowance, if for instance, if you were to fully cash in the bond in year four, or if certain chargeable events happen, which I'll come on to in a moment, then you may have income tax to pay. So the point I should make on tax is that these bond vehicles, they're subject to the income tax regime. They've nothing to do with capital gains tax. So that's a really common misconception I see is that people assume that these investment bond wrappers are subject to the capital gains tax regime. They're not, they're subject to the income tax regime. The confusing terminology comes because of the fact that in determining whether you are subject to an income tax charge, it's labelled a chargeable event. Chargeable event occurs and you may be subject to an income tax regime, but it's nothing to do with capital gains tax. So chargeable events, what exactly are they? Well, tax may be triggered if you encache the bond, you withdraw too much, the bond matures, or in some cases with poor planning, the bondholder dies. And I won't go into the details around that in this episode, but I have seen that in the past where people have set up these bonds poorly, perhaps without regulated advice, and there could be a tax time bomb waiting to happen. I've had to unwind a couple of them in my career. So, what happens is there's a chargeable event happens in one year where you make a sizable withdrawal or you want to get more of your money back than the 5% allowance, and you may have a hefty tax bill. Now there's something called top slicing relief, which is an income tax relief that essentially helps to mitigate the extent of the income tax charge. I'm not going to go into the details in this because it's an already technical episode and that really would lose you money nerds, but just be aware there's something called top slicing which can help to mitigate the total tax charge you pay. So let's regroup. Investment bonds, they can be suitable because they're a way of sheltering your wealth from ongoing income tax. However, when you need to make withdrawals from the bonds, there could be a potential for income tax. Now, the pros of investment bonds is that tax deferral concept is if you expect to be in a lower tax band later than you are today and you want to avoid increasing your taxable income today, they can be a great shelter for you. In comparison with if you put the money in a general account, you could be subject to ongoing income tax, ongoing capital gains tax, it can become an ongoing administrative tax headache. Whereas an offshore or onshore bond is a way of you almost rolling up that money and pushing the tax position down the road. And as I said, if your tax position is broadly expected to be similar both now and in the future, that would typically steer you towards an onshore bond from a tax perspective. Again, tax should not be the only driver. And conversely, if you anticipate having a drop in income in your retirement, then you may be steered towards an offshore bond. Second advantage is you've got income flexibility within the bond. So every year you're entitled to 5% of the bond back. This almost provides you with this regular tax-deferred income, and it doesn't immediately affect your tax bans. So if you take or if you generate a taxable income of five grand in a general account, that would be counted towards your total tax position in that year, which may have a knock-on effect with other taxes you're paying. But an offshore or an onshore bond allows you to repay that 5% every year and it's treated as a return of capital, it's not income. So that income flexibility can be really beneficial for retirees who are managing their income, it can be for people bridging gaps before pensions kick in. And of course, it's functions in a similar way to an ISA in that regard. Offshore bonds, onshore bonds, despite them seeming pretty complex from what I've said so far, they're actually simplified from a tax reporting stance. Because of the capital gains tax issues I outlined earlier, more and more people are being dragged into the tax reportable net. They're having to do tax returns or notify HMRC of a tax perspective of them. And this, uh contrasting with a bond, means you've got no annual capital gains tax exemption to claim, no annual capital gains tax to report, no dividend reporting. Everything is very much handled within the bond. So it's a simple from an administrative, tax-administrative angle. Bonds can also be very lucrative and good planning vehicles when they're working alongside wider family planning, be this assigning bonds to younger generations of your family, and also trust planning. I'll come back to that a bit later. So the cons of investment bonds is they potentially can be higher tax for some, because gains are taxed as income, not capital gains. So this can mean for people who do unforeseen timing of withdrawals, they don't plan around wider tax positions, you could be paying sizable levels of income tax, be it 40 or 45%, in comparison to capital gains taxes on a general account, which is lower than that. They're also pretty complex. Even financial advisors I've seen get confused around these because you get into the realm of chargeable event calculations, you need to be understanding of top slicing relief, you need to be more au fay with assigning bonds out to younger generations and doing things in the correct order to make sure you're moving tax positions from one person to another. It can become a bit confusing. It's also a bit less transparent from an ongoing tax perspective because compared with a general investment account, you don't see the tax building up annually. As I said, a general investment account, every year you would file your tax return, you'd note how much you've accrued in income tax from the general account and also how much you've accrued in capital gains tax from the general investment account. But with one of the investment bonds wrappers, you don't see this happening because it's tax deferred. You don't pay an ongoing tax unless you trigger sizable withdrawals. Um but from a perspective of in the future, you could have a nasty shock if you don't time things in a good manner. So you need to go into this with your eyes open. Of course, charges, it's typically going to be higher. Um typically the products to actually hold the products themselves to be annual administration charges. I mean it's not ridiculous money, but it is more expensive than your more vanilla tax wrappers. So structure matters, is what I'm saying. So where do investment bonds fit in? So given the tax landscape we're in in the UK, this is where things can get a bit interesting. Scenario one can be if you're a higher earner today and you anticipate having a lower income later. Maybe you're a director of a company, maybe you've got high taxable income and you're planning retiring in five to ten years. An offshore bond could help you to grow the funds without a tax drag within a general investment account, and it can allow you to structure your withdrawals in a planned manner in the future to keep them under a lower tax ban, perhaps, in retirement, because in retirement, let's say you don't have any guaranteed income other than your state pension, so you've got control over your withdrawals in the future. The scenario number two I would go into is that bonds should really only come into their own when you've exhausted your ISA and your pension allowance. So if you've maxed out your pensions, you've fully utilized your ISAs. Similarly, if you're looking at this holistically as a couple, you maxed out both of your pensions, both of your ISAs. If it's next generation planning, you may have explored general junior ISAs. Investment bonds really come into their own as a next-tier planning tool and can be really relevant for people who may be squeezed on their annual allowance because of the tapered annual allowance tax charges. For instance, if you're earning significant amounts of money, you may not have much scope to pay into pensions in a sizeable way. So investment bonds can be beneficial in that regard. Scenario three, maybe a good way of managing your income in retirement because, as I said, you can take 5% annual withdrawals from the bonds, and it is typically not taxable in that year, it gets carried forward, but it doesn't push you into altern and higher tax brackets in that year compared with the likes of general investment accounts. Similarly, if you take a withdrawal from a pension as a reminder, beyond your taxable free allowance, your tax-free cash, you will pay income tax on any withdrawals you make, whereas that does not occur with an investment bond. And I should point out for clarity, when I say to you you can take 5% a year from your bond for 20 years, you can still get your hands on your money whenever you want. It is not to say that it's locked up and that's all you can take every year. The 5% point is that's almost the freebie you get every year. So in year three, let's say you would have accumulated 15% freebie. If your pot had grown beyond that and you had a little bit of income growth in there as well, you may have to pay more tax. But equally, if your investment bond had dipped and fell in value, you could take more than your 15% cumulative. So it's not restrictive. Again, I really don't get want to get into the weeds here, folks, but it's please just take one thing away it's not a case of you write a check for 100 grand and you can only get five grand back in year one, you can only get five grand back in year two. It's not as restrictive as that, it's more just this goes into the details how the tax regime works within the bond wrapper. So, as I said also, bonds can be very beneficial from a perspective of intergenerational planning. Case in point I've seen is that people may use these to shelter their wealth, and then the money grows free of tax and in an offshore bond stance at least, and then they assign it to younger generations, children, grandchildren who may have close to no taxable income, meaning that they can move the point of tax away from them to the next generation. So, really good tax planning in that regard. Bonds are also better to be used in trust planning. So if you've got things like a discounted gift trust, loan trusts, um, gift and loans, again, not getting into the weeds here, but typically if you've recommended or been recommended one of these from your advisor, or you've invested in one of these trust vehicles in the past, it's highly probable that the actual underlying investment wrapper within the trust will be a bond wrapper rather than a general investment account. And often, more often than not, it's because that's tax administration administration simpler for your trustees than a general account would be. And as I said, it's a really good way of moving the point of tax to certain beneficiaries in a really tax advantageous way. So it allows you control tax efficiency and a good level of wealth transfer. So there's a lot there I know, but maybe can I just regroup this? Final thoughts. Investment bonds are just like pensions and ISAs and general accounts, but they're a bit more nuanced and have a more limited scenario in which they can apply and be good part of your planning. They're not inherently good or bad with anything in financial planning. They are complex and that often makes me steer away from them because complexity can lead to disillusionment and disengagement with your financial plan. I want all my clients and you listeners to be as positive and on top of your finances as you can be, and bonds can be a bit overwhelming. But that's not to say that you should be disregarding them. They're not suitable for everyone, but they are very powerful in the right situation. More so now than they were a few years ago when the capital gains tax levels were higher. Because when the capital gains tax exemption was higher and capital gains tax rates were lower, less people were being caught by tax issues. Whereas bonds now are in more flavor because they essentially meet the gap for people who have perhaps accruing significant levels of capital gains tax in their general account. And as with anything on any of these things, is as a reminder, it's the financial assets that you hold within these wrappers that will drive the long-term growth projection of your plan. You just want to almost strategically have your wealth across these tax wrappers because each of them will have certain drags at certain points of time in your life, and all of all that will happen is slightly drag down the headline growth within your financial plan. So that's all these wrappers are, that's all that taxes are essentially, is a charge on the growth within your financial plan. And to be more specific, they can be particularly useful for you if you're exploring deferring your taxes, reducing high taxes now with a view to controlling taxes later. They can be good for income planning, they can be used for state planning, and obviously they can be used as part of a diversified tax wrapper stance in that giving your financial plan as much flexibility in the future as possible. So, for instance, a client who may have a general account, uh ISAT pension, and some money in investment bond, you really have covered yourself from all bases there. You've got a lot of flexibility in terms of how you structure your income in the future. But obviously, at that level, you do need regulated financial advice because it does get quite complex understanding how all the products interact with one another. So I'm going to bring it to a close. It's longer than we usually try and do in the podcast, but I hope you found this one interesting, Money Nerds. Do let me know if you have or if you have any questions, you know where to find me. I can't give you regulated financial advice, but I can give you some pointers and things to be thinking about. So reach out to me if it's of interest. If you've heard about investment bonds before and you felt unsure, fear not, that is completely normal, it's really confusing, and as I said, we use the same terminology repeatedly in financial services, which does not help. But when used correctly, they can be relevant to your financial plan. So I really wanted to educate you today, money nerds. So I hope you found that helpful. I hope it's not been too overwhelming, and I hope it's been a good Friday for you so far. I'll catch you next week. We're racing towards 150 episodes of Heads Up on Money, which is absolutely mad. But hopefully you're enjoying it as much now as you did 148 episodes ago. I've been Benjamin Mitchell, you've been the Money Nerds. I thank you as always for listening. Enjoy your weekend, whatever you're up to, and I hope the sun finally comes out in Scotland and beyond the