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Is your income being held hostage?

Investment bonds provide some tax benefits, but if held for a long time, they can also hold your income to hostage.

This article may apply to people that have taken out an investment bond because they were:

  • Higher rate tax payers during their working lives and started taking income after their bond had grown in value – the Investment bond would have capped any income tax on the growth to the basic rate instead of paying tax at your prevailing higher rate.

  • Investors seeking income where the income from their savings would have taken them into a higher rate income tax bracket.

  • Investors that were basic rate tax payers at the time the bond was set up and still are now.

Investments in a bond defer the higher level of tax on the growth and income and only incur the equivalent of basic rate tax, currently 20%, payable by the bond provider. . It is when the bond is surrendered that it is assessed against your personal income tax arrangement. This deferment means that you can incur the tax payment at a time that is convenient to you.

During the period of ownership the investor can receive an income in the form of a fixed payment of up to 5% of the original sum invested without causing an immediate income tax liability. This is because it is deemed as a return of capital. This is possible for up to 20 years, i.e. when 100% of the capital invested will have been returned.
There lays the problem, as to mitigate income tax you are limited to taking 5% income from the original investment. Over time the value of the sum invested may have grown substantially.

Sylvia's Story – How it started

Sylvia placed £50,000 into an Investment bond segmented into 100 policies in 1988, five years before retirement. When she retired, aged 60, she started drawing 5% of the original investment per year. This gave her an income of £2,500 per year [£208.33 per month]. However, 20 years later in 2013, she was still drawing the same amount of fixed income. You will appreciate that £208.33 does not buy the same today as it would have done in 1993 due to inflation. The value of the investment had fluctuated over the years, but by 2013, the value was £153,000.

For Sylvia to continue taking 5% per year beyond 20 years would mean that every income withdrawal that Sylvia was receiving had now become a chargeable event.

You should seek advice if you are receiving Chargeable Event notifications from your investment bond provider.



Sylvia's story – How the past then came back to haunt her

The effective income Sylvia was drawing from the Investment bond was 1.6% [£2,500/£153,000] of its current value at a time when the yield [natural income] on the underlying investment was actually 4.8% causing the fund to continue growing whilst Sylvia was now struggling to pay her bills.

If the sum of £153,000 was invested into an investment bond today, at 5% fixed income, she would be able to receive £7,650 per year, £637.50 per month, which is an increase of £429.17 every month. At a time when income from bank accounts and cash ISAs are low, this income would be gratefully received.

Alternatively if she had been invested in an investment ISA or a general investment account she would be able to take the natural income, which at 4.8% would be £7,344 per year. Also, over the past 20 years, all of the investment could have been made tax efficient using annual PEP and ISA allowances. This means she would been able to take an income without paying income tax and even surrendered the whole investment without paying any further tax on any gains.

Sylvia's Story continued – How tax held her income hostage

Sylvia only had £3,000 of basic rate income tax allowance left after considering her pension and rental income. This would mean that she would not be paying additional tax on the chargeable events. However, if her income increased she would end up paying additional income tax on the income from the bond.

If the whole bond was surrendered she would be liable for income tax on the gains after top slicing. This can be calculated by dividing the total net gain by the total period she has held the investment. When added to her pension income, this would have taken her into the higher rate tax bracket by £3,120 which would lead to an income tax bill of around £15,000.

If you are suffering from this problem and need the extra income we recommend that you contact us for guidance before you start surrendering investments.

We also strongly recommend that you seek advice from your Accountant or Tax Adviser before surrendering any investment.

The solution - How we resolved Sylvia's Story

By stopping her income from the bond and fully surrendering 35 segments, she was able to raise £53,550, which when assessed for tax using top slicing, only added £2,142 to her income. This meant that no further tax was payable by her.
Sylvia was then able to use the ISA allowance either side of the tax year and place £30,000 into a new investment bond drawing 5% per year. Sylvia's income subject to income tax would have not increased, so allowing her to surrender another tranche next year whilst avoiding a potential £15,000 tax bill.

If you are in a similar position as Sylvia, or have other questions about investment bonds, call us now to arrange a free no obligation consultation.

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