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Personal Finance: Bond, licensed to kill tax

HANDS UP anyone who likes paying tax. It is probably true to say that almost no one does so with any great sense of joy. Hence the likely long-term attraction of tax-free wrappers available on the new Individual Savings Account (ISA) that was launched by the Treasury earlier this month.

With-profits bonds don't have the same immediate tax benefits of ISAs or the PEPs that were replaced by ISAs. However, if they are judiciously used, with-profits bonds can be used to defray or even to reduce people's tax liabilities.

However, first you need to ask: what exactly is the tax position of a with-profits bond? Essentially, it is a "tax-paid" investment, in that it is already subject to a basic rate of tax, after deductions for expenses, within the life fund in which it is invested.

Higher-rate taxpayers will face an additional demand when they encash their bond. This also means that, for non-taxpayers, the fact that they can reclaim tax if they keep their savings in a bank or building society account means a with-profits bond may not be generally suitable.

However, the fact that with-profits bonds are treated as a life insurance bond means that current rules allow up to 5 per cent of a bond's original investment to be taken as income each year, without any further tax liabilities, for up to 20 years.

This is based on the assumption that, over a 20-year period, the total capital investment could be returned - and the Inland Revenue regards this "income" as capital being returned. Any further liability is deferred until the bond is encashed.

Higher-rate taxpayers can take advantage of these rules by waiting until they move back into a lower tax band (at the time that they retire, for example) before they encash their bond. This would make them liable to no more tax at this point. Meanwhile, there is no capital gains tax to pay on any growth in the value of the investment itself.

Moreover, the 5 per cent "capital as income" rule is particularly effective when used by taxpayers over 65. This is because anyone over normal retirement age receives an allowance of pounds 5,720 (in the 1999/2000 tax year) before any tax is paid. This mounts to pounds 5,980 for anyone aged 74 or over. This adds pounds 1,385 to the standard tax break of pounds 4,335 for anyone aged over 65 and pounds 1,645 for those aged over 75.

However, there is a sting in the tail: for anyone earning over pounds 16,800 a year, this excess allowance is taken away at the rate of pounds 1 for every pounds 2 earned, so that anyone under the age of 75 earning more than pounds 19,570 loses that allowance entirely. In effect, this amounts to a marginal rate of tax of more than 34 per cent on that sum.

But not if you are taking income from a with-profit bond. Because it is not classed as total income by the Inland Revenue, no allowance is lost. It should be noted that, when the bond is finally cased in, each of the 5 per cent slices taken in previous years may be added to the total current value of the policy to check any tax liability. But only borderline or higher-rate taxpayers need worry.

Also, at encashment each of the 5 per cent slices taken will be counted towards "total income" for that year. This means losing a proportion of the age-related allowance in that year. But the amount gained by the annual addition of income through the with-profits bond should easily cancel out that final year's loss of allowance.

`The Independent' has produced a free 24-page `Guide to With-Profits Bonds'. Written by Nic Cicutti, this paper's personal finance editor, it examines the arguments for and against investing in bonds. For your copy of the guide, sponsored by The With-Profits Bond Shop, call 0845 2711007.