Tax Inefficiencies of Investment Bonds – Cornwall Live


by Peter McGahan

Have you ever heard of “rebasing” an investment? I hadn’t heard that term in 10 years, but in the last two weeks it came up twice, much to my amazement.

This was a term used by financial salespeople to essentially ‘churl’ investment bonds, resulting in heavy charges to the client every time.
It looks like this: the financial advisor sells an investment bond for its “tax efficiencies”. An investment bond represents tax at the basic rate as it grows and you are allowed to make withdrawals of 5% per annum without being subject to tax. I’m sure you can quickly see that the bond is not tax-efficient, especially when compared to an ISA or pension, which grows tax-free.

A range of unit trusts, or their equivalent, could be invested in and annually use the capital gains deduction from that investment to turn it into an ISA or pension. In short, there are many more tax-efficient options to consider before issuing a surety bond. As for the “20-year tax-free withdrawals”, it’s just about getting your money back over time, ie 5×20.

And that’s where the bond advisor/seller can come in. Over five years, you may have taken 5% per annum of the original principal, but the bond may also have increased in value. The advisor asks you if you want a higher income, ie 5% of the new higher value. Naturally you accept, so he cashes the bond and since the gain does not place you in a higher tax rate, there is no tax to pay. Perfect?

The new bond is sold to you “with no upfront cost”, so you think you can’t lose. However, the set-up costs of the new bond are considered set-up costs over a period of five to seven years to pay for “commissions” and other set-up costs. When they’re sold to you as “no upfront”, ask the advisor what the cashout value will be on day two, and the reality will quickly sink in as the fee will be taken immediately.

Every five years, the advisor can come back and ask the same question about “more income”, and over a 25 year period, you could have paid almost 38% more fees, because the commission was up to 7, 5%. These days independent financial advisors are not paid on commission, so the allure of making a quick buck has been taken away. However, not all advisors are independent, choosing instead to work for one company, so keep that in mind when taking advice.

If you have an investment bond, you might want to take a look at its tax efficiency. The cumulative impact of tax levied as it increases hacks into your returns. Let’s say it grew seven percent a year for 25 years. Taking into account the 20% tax, you would reduce to 5.6%.

An investment of £100,000 gross of tax would yield £152,264 (almost 39%) more than the ineffective bond. The annual allowance for an ISA is £20,000 and this is per person in the household so a couple can invest £40,000 per tax year. When there is an obvious choice of ISA, it is difficult to see why the investment bond would be used so that you can move the capital to a more tax efficient option, as above.

An independent financial adviser can assess the fees as well as any potential tax payable to ensure you are not burdened again. To assess any tax liability, simply calculate the gain and divide it by the number of years you have had it. If this portion of the gain, added to your income, does not place you in a higher tax rate, you will no longer have to pay tax.

Hopefully, the bond is also written in segments, which would give you more flexibility in that you could cash out each segment to ensure you don’t go to a higher tax rate. If the bond you have is offshore, that’s a whole other story and I’ll explain that another time.

If you have an investment question or would like investment advice please call 01872 222422 or email [email protected] or visit us at www.wwfp.net

Peter McGahan is the managing director of independent financial advisor Worldwide Financial Planning. Worldwide Financial Planning is authorized and regulated by the Financial Conduct Authority.

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