Investing a lump sum in a variety of available funds
Investment bonds are life insurance policies where you invest a lump sum in a variety of available funds. Some investment bonds run for a fixed term, while others have no set investment term. When you cash investment bonds in, how much you get back depends on how well – or how badly – the investment has done.
When you invest a lump sum, the minimum is usually between £5,000 and £10,000. Most investment bonds are whole of life. There is usually no minimum term, although surrender penalties may apply in the early years.
Terms and conditions
Usually, you have a choice of funds to invest the money into. At surrender or on death (or if not a whole of life bond at the end of the term), a lump sum will be paid out. The amount depends on the bond’s terms and conditions and may depend on investment performance.
Some investment bonds may guarantee your capital or your returns. These guarantees usually involve a counterparty. If so, they carry the risk of counterparty failure. You have a choice of two types of funds: with-profits or unit-linked. Both have the same tax rules where tax is paid on both growth and income accrued in the fund by the insurer.
Variety of investment funds
Some investments offer a guarantee that you won’t get back less than you originally invested. By choosing a bond that allows you to invest in a variety of investment funds and switch funds easily, you may weather the ups and downs of the market better. Because there’s an element of life assurance, your investment bond policy may pay out slightly more than the value of the fund if you die during its term.
All gains and income earned within an investment bond are taxed at 20% and paid directly out of the investment bond. Withdrawals of up to 5% a year are allowed for up to 20 years without incurring an additional tax charge. If you don’t use your 5% allowance in a given year, the allowance is carried over to the following year – for example, if you make no withdrawals in year one, you could draw up to 10% the following year without incurring a tax liability.
Minimise an income tax bill
So if you’re a higher-rate or additional-rate taxpayer, paying 40% or 45% tax on income in the current tax year, an investment bond can minimise your Income Tax bill. However, your tax bill does not disappear entirely. Instead, the tax is deferred, and any additional tax due will be payable at the time you cash in the bond, or when it matures.
All capital gains are treated as income at this point. Although tax at 20% has already been deducted, you may have an additional Income Tax bill if your gains push your income over the higher or additional-rate tax threshold in the year they mature.
You may be able to avoid this by using a method known as ‘top slicing’. Top slicing works by dividing your profit over the lifetime of your bond (including withdrawals) by the number of years the bond has been held. If the resulting figure, when added to your other income for the tax year, is below the higher-rate tax threshold, there is no extra tax to pay. However, if the top-sliced profits still push you over the higher-rate tax threshold for the year, then additional tax must be paid on the entire gain.