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Case study: Tax advantages of bond segments

One slice at a time…“Segments are the key to tax-efficient surrender”


 The problem: How can increasing the number of segments in an investment bond be used to help financial planning?


The solution: When making withdrawals from a bond, there is no simple rule of thumb that suggests whether it is better to use the 5% allowance or fully surrender some segments. It is down to the individual circumstances each time.

Although using the wrong method of withdrawal can be disastrous, getting it right can bring considerable tax advantages. Much has been written about this and most advisers will be aware of the importance of making the right choice.

But what is less commonly discussed is the significance of segments in a bond. The option to have multiple segments, and to cash them in separately, offers great flexibility.

For example, David, who is a 45% taxpayer, puts £1 million into an offshore bond. The bond has 10 segments, so each segment is worth £100,000. After three years, the bond has increased in value by 10% and David now wants to withdraw £180,000 to help buy a property for his daughter.

He can withdraw £150,000 using the 5% tax-deferred facility, but cannot make up the remaining £30,000 he wants by segment surrender, because each segment is now worth £110,000. To get the exact amount he wants, David will need to cash in one segment for £110,000 and take the remaining £70,000 using the 5% allowance.

He will then have a chargeable gain of £10,000 on the segment he has cashed in, giving him a tax bill of £4,500.

Suppose, instead, that the bond has 1,000 segments. David could now cash in 28 segments for £30,800, taking £149,200 under the 5% tax-deferred facility. His chargeable gain on the segments would be £2,800, with a tax bill of £1,260. He would have saved £3,240 in immediate tax.

Of course, if David remains UK-resident, he will eventually have to pay tax on the 5% withdrawals he has made when he finally cashes in the bond, but his tax rate may have dropped by then.

In fact, David could potentially improve the tax position further by assigning segments of the bond to his daughter, who is a basic rate taxpayer. She can then cash them in and pay tax at her own rate. Again, more segments can be better: With only 10 segments, he can assign two segments for £220,000 – £40,000 more than his daughter needs – or one for £110,000, leaving her £70,000 short. In the first case, she would have a tax bill of £4,000. In the second case, it would be £2,000, but David would then need to withdraw the extra £70,000 using the 5% allowance and would eventually pay tax on it himself, if he remains UK-resident.

With 1,000 segments, David can assign 164 segments to his daughter, worth £180,400. Her tax bill on cashing them in is now only £3,280 and David will have no further tax liability.

If the bond had more segments, it would be possible to refine it even further. This might be more important where a bond is held in trust for a family with several beneficiaries – children and grandchildren, for example.

The most tax-efficient way to take money out of the trust will usually be through assignment of segments of the bond. The beneficiaries can then cash in and pay tax at their own rate, instead of the trustees making withdrawals and paying the trust rate of 45%. But if the bond had only 10 segments, it would not be possible to assign small amounts.

This would be particularly important in the case of a Discounted Gift Trust, where the settlor may already be using all of the 5% allowance for his own regular payments. Any withdrawals by the trustees will then trigger a tax charge at 45%. On the other hand, if they surrender, or assign, a large amount, it could jeopardise the settlor’s future payments – and possibly constitute a breach of the trust. The greater the number of segments, the more flexibility they will have to assign small sums to beneficiaries.

Tax-efficiency is one of the main attractions of a bond, especially an offshore bond, for a higher net worth investor. If there aren’t enough segments to allow flexibility, much of the value of this feature will be lost.



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