Tax break on bonds poised to bite the dust

With insurance products expected to lose a big selling point, Simon Hildrey asks how investors should respond

Savers may have just a little over a month to take advantage of one of the main benefits of insurance bonds. It is widely predicted that the Chancellor will use his next Budget to rescind the rule that lets policy- holders defer tax on 5 per cent of their original investment in the bonds every 12 months by taking it as income.

Savers may have just a little over a month to take advantage of one of the main benefits of insurance bonds. It is widely predicted that the Chancellor will use his next Budget to rescind the rule that lets policy- holders defer tax on 5 per cent of their original investment in the bonds every 12 months by taking it as income.

Abolition of the 5 per cent withdrawal rule would affect not only savers seeking income, but also trusts taken out to mitigate inheritance tax liabilities, many of which use insurance bonds. And with about £20bn invested in insurance bonds last year, a lot of people will be hit.

Insurers argue that savers wishing to exploit either benefit should consider taking out an insurance bond before 5 April, the end of the tax year. Even if Gordon Brown does change the rules, it is unusual for tax legislation to be enacted retrospectively. So it could be the last opportunity to get the benefit.

The insurance industry expects the rule to be abolished because this was the recommendation of Ron Sandler in his review last year of the £800bn long-term savings market. He argued that the 5 per cent withdrawal allowance should be removed because investment decisions should not be determined by tax considerations. He also thought it regressive as "its benefits are focused on higher-rate taxpayers".

In his pre-Budget statement last autumn, Mr Brown said he was looking to take forward Mr Sandler's recommendations on tax. Since then, the Association of British Insurers, which represents the insurance industry, has met the Inland Revenue to discuss whether and how the rule change should be implemented.

The withdrawal rule allows investors to put off paying income tax on 5 per cent of their original investment for 20 years or until they cash in their policy. Higher-rate taxpayers benefit in particular, as gains within bonds are taxed at the basic rate of 22 per cent. Another 18 per cent is levied only on gains for higher-rate payers when they cash in their bonds.

The insurance industry is naturally opposed to the abolition of the rule. Steven Whalley, product marketing manager at Scottish Equitable, says the bonds have a "simple tax status" as well as benefits: "Savers do not have to fill out a self-assessment tax form or notify the Revenue of gains from an insurance bond, as they do with unit trusts."

Colin Jelley, marketing development manager at Skandia, says: "If savers want to use the withdrawal rule and have the money to invest, they should buy a bond now. They can invest in cash and bonds if they do not want to risk equities at the moment."

He argues that even if the Government does not introduce retrospective legis- lation, it may not allow top-up investments on existing policies to benefit from the 5 per cent allowance.

Investors are being advised that in case the rule is changed and this is done retrospectively, they should buy bonds with no exit charges.

Mr Jelley is critical of the planned change as "it flies in the face of government attempts to simplify savings products, including pensions. The Revenue is likely to use a part disposal formula to calculate tax on insurance bonds in future, but this could be more complicated than the current situation."

According to Mr Jelley, the part disposal rule would calculate the level of tax to be levied on insurance bonds through a complex mixture of the income taken and the gain achieved. If a policy grew in value by 5 per cent every year and was cashed in after 10 years, Mr Jelley argues that the tax bill would be the same under part disposal as it is under the current system.

The difference is that tax would have to be paid every year on gains rather than only when the bond is encashed. This would have a negative impact on retirees, as it would reduce their personal allowance and force the over-65s to pay more tax.

While Adrian Shandley, director of the independent financial adviser Premier Wealth Management, believes this is a bad time to abolish the withdrawal rule, he argues that investors might be better off with unit trusts anyway.

"In a unit trust, an investor can offset losses in one year against gains in another, which you cannot do in insurance bonds," he says. "Gains in unit trusts are taxed as capital gains rather than income. Investors can use their allowance of returns of £7,700 a year free from capital gains tax. Fund managers within insurance bonds pay capital gains tax that cannot be reclaimed."

As if the situation wasn't bad enough already, Mr Shandley sounds another warning for with-profits policyholders: "Growth in bonds is supposed to exceed the 5 per cent withdrawal a year. But as with-profits bonus rates have come down, policyholders need to ensure a 5 per cent withdrawal is not eating into their capital."