Bonds can beat tax rises

15 March 2010 8:00 am

Two major income tax changes for highearners take effect on April 6. Both of these changes mean that highearners may end up paying substantially more in tax on some slices of income than the current top rate of 40 per cent.

Bonds can be used to avoid annual income tax liabilities on investment income, so these changes mean bond investments will become particularly attractive to high-earners.

Income tax personal allowances are being removed from 2010-11 onwards for people with taxable income over £100,000. The allowance for 2010-11 is £6,475 and those affected will pay equivalent to a rate of 60 per cent on income between £100,000 and £112,950.

Bonds can help reduce this where overall income, including investment income, is within the range £100,000-£112,950. This is because there is no annual income tax liability on investments held in bonds. Personal income tax liabilities are deferred until a charge able-event gain arises. This will usually only happen when proceeds are taken from the bond, so the investor can control and delay the tax point and save tax as a result.

Looking at how this might work, take the example of someone earning £97,000 and with interest on bank deposits of £5,000. Their total income is over £100,000 so the effective tax rate will be 60 per cent on the £2,000 excess.

If that person puts the capital that generates the interest into a bond, they have removed their annual income tax liability on investment income and at the same time have reduced their income back below £100,000 - so back into the 40 per cent tax bracket.

Gains on the bond will be taxed eventually but the investor can decide when to trigger the income tax liability on their bond and this means
they may be able to cash in the bond and pay tax when their tax liability is at 40 per cent.

For example, if the person’s income falls back to £80,000, perhaps because of a lower than average bonus, then their highest tax rate would fall
back to 40 per cent and this rate would apply to their bond gains as long as these were under £20,000.

This example also shows that bonds can be particularly beneficial for people whose total income fluctuates - per haps because they are selfemployed. The other group that might be able to save income tax by using bonds is people with income over £150,000 - including investment income - who will be 50 per cent taxpayers from April 6.

Again, if bonds are not used, investment income will be taxed annually and so tax will be due on this at 50 per cent. But where savings are held
in bonds, there will be no personal income tax liability until money is withdrawn.

This means the 50 per cent rate can be avoided completely if proceeds from the bond are not cashed in until the investor is paying tax at lower rates, either because tax rates have fallen or the person is no longer a UK resident or has retired.

When someone decides to reduce their highest tax rate by investing their savings in bonds they will have to decide whether an onshore or an
offshore bond meets their needs best. One factor that may draw that person to offshore rather than onshore investment bonds is the fund choice available within portfolio bonds.

It is important to remember that using bond wrappers might not be appropriate for everyone, particularly because using the bond will often mean a loss of investor protection.

Bank deposits are a good example of this. An investor who holds a fixed-term deposit with a bank based in the most common jurisdictions will be able to benefit from a deposit compensation scheme if that bank becomes insolvent. This is not true of deposits held within bond wrappers,
however, as it is the life company that owns the deposit and the life company will usually not be covered by a guarantee scheme.

This is a downside but as long as the investor is clear that the bond is a suitable investment for their circumstances and risk appetite, it can certainly have a place in saving income tax in a period of high tax rates as well as offering more traditional tax planning opportunities, such as inheritance tax planning.

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