How can onshore bonds be used in estate planning?
- 19 October 2020
- 15 minute read
Onshore bonds are a type of insurance policy with certain tax benefits .
This can make them helpful when planning your retirement income .
They can be used as part of your estate and inheritance tax planning .
Onshore bonds are a type of life insurance policy which allow you to invest tax efficiently. They are usually classed as “single premium life assurance contracts” [1]. That is they are set up on the payment of a lump sum rather than by regular monthly instalments.
But this is a bit of a misnomer because you can usually top up your investments at a later date if the ability arises: either as additional single payments or on a regular basis.
The life insurance element is usually nominal [2] but an onshore bond gives you and your investments access to the tax efficiencies of an insurance wrapper.
How do onshore bonds work?
Onshore bonds as “non-income producing investments” [1] which gives them a different tax treatment from other UK-based investments. This can provide valuable tax planning opportunities for individuals.
In an onshore bond the life company pays corporation tax at 20% [9] on any income received and on any capital gains. HMRC regards this as equivalent to the policy holder having paid capital gains tax (CGT) and basic rate income tax [2] and investors have no personal liability to either of these on any profits from the bond.
So what makes onshore bonds useful in tax planning?
Firstly, onshore bonds are not tax free [3]. But they allow you to postpone (“defer”) when you have to pay these taxes until a time when you might be in a lower tax bracket [1].
Onshore bonds are normally made up of segments [3], typically between 20 and 100, and, as we shall see, this can be very useful in planning how much tax becomes liable and even who pays the tax when it falls due. This can be helpful from either from an income tax or an inheritance tax perspective.
What is the difference between onshore and offshore bonds?
Offshore bonds work in a similar way to onshore bonds but are based in locations where the investments are largely free from tax [1]. They can be based in locations that are truly “offshore” such as the Chanel Islands and the Isle of Man or in enclaves with a special tax status such as Dublin.
And according to the Prudential there is one main difference between onshore and offshore bonds [1]. Offshore bonds are not subject to UK corporation tax so investments in an offshore bond could grow potentially faster. Although there can be no guarantees that this is the case.
But it isn’t all one way. Many offshore tax authorities charge something called “withholding tax” [1] on any interest paid by bonds or dividends paid by stocks and shares held within the funds. This is a tax that cannot be reclaimed. And offshore bonds tend to have higher charges [2] which may affect the overall long-term return.
It also means all gains will be taxed at your highest marginal rate for income tax [1]. You could also lose some or all of your entitlement to personal tax allowances.
How can you use an onshore bond for tax-efficient income?
One of the unique features of an onshore bond is the ability to withdraw up to 5% of your premium [3] every year. Because this is from the initial capital invested, you do not have to pay any tax on it and it doesn’t even have to be declared on your tax returns. You might see this referred to as the "5% tax-deferred allowance" [1].
And every time you top the bond up, 5% of that additional investment [3] becomes available.
So if you’re a higher rate or additional rate taxpayer, tax-deferred withdrawals from an onshore bond can provide additional funds without incurring additional income tax.
According to Professional Paraplanner [3], the allowance is cumulative, which means any unused portion can be rolled up for future use.
You could wait until the 20th anniversary and take out the whole initial investment if you so wish without any tax liability. However, the total withdrawn cannot be greater than 100% of the amount paid in. At the end of the 20-year period, or if you decide to cash in early, a final exercise is done to calculate the total chargeable gain and it is at this point that any income tax has to be paid.
Our recent Family and Finances Report found that 65% of those over the age of 60 plan to pass on their wealth to their children or grandchildren after they die, and a further 17% plan to share their wealth during their lifetime. With mounting education costs and house prices, helping your grandchildren could be rewarding in more ways than one.
How can you use onshore bonds for inheritance planning?
Assign portions of the bond
If you are a higher-rate tax payer, one of the first things you could consider is handing over all or part of the bond to someone else. Provided you do not receive anything in exchange – and this can also mean non-monetary benefits – this is not regarded as a taxable event.
But if you do receive money or some other benefit in kind, this would be regarded as a chargeable event and you will be liable to pay income tax on all the gains [4] made within the bond since you set it up.
So you could assign some of it to your spouse or civil partner before the bond’s maturity date [2]. If they are a basic-rate tax payer, no further tax will have to be paid. And if they take out more than the 5% permitted, it will be assessed alongside all their other income.
You could also assign it to your children, but this could have inheritance tax implications if you die within the next seven years. This is known as a potentially exempt transfer. But remember that a gift must outright and unconditional.
Read more: Intergenerational wealth transfer, it’s all the rage.
According to the Charging for Residential Accommodation Guide, if the bond has been assigned to someone who is in long-term care – or they inherit the bond as one of the lives assured – the assets within the bond are generally excluded from local authority capital means tests [5]. But any 5% deferred withdrawals will be considered income. This could therefore affect eligibility for support.
Place the bond in a trust
If you want to retain control over the gift whilst potentially placing it outside your estate for inheritance tax planning you could consider placing the bond within a trust. There are many types of trust to choose from depending on whether you want to retain an interest in the onshore bond and the level and nature of that interest
There are two types commonly available known as Absolute trusts and Discretionary trusts. Absolute trusts are normally used for minors who can take possession of the trust on reaching 18 (16 if the trust is written under Scottish law). Discretionary trusts offer trustees more flexibility.
Read more: The role of trusts in estate planning
But consideration should be given to the tax rules that apply to Trusts. Because in the event of a chargeable event happening – such as the bond maturing, or the death of the person who set the bond up – the trustees would be liable to pay 45% on any gains made [8].
Even within a trust, the trustees can take advantage of the ability to assign segments to different beneficiaries [1]. Provided that beneficiary is over the age of 18 and is named. The beneficiary can then surrender the segment and declare any gains on the ir annual income tax return.
if the beneficiary decides to keep the bond running – to withdraw future 5% deferrals – they need to consider that the investment bond will have to be surrendered upon the death of the original life assured.
Additional lives assured
Another option could be to have the bond written with more than one life assured. In this instance, the bond will continue until the last named beneficiary has died.
What are the disadvantages of using an onshore bond?
An onshore bond is not generally as tax efficient as an ISA [6]. For example, nil-rate taxpayers cannot reclaim the corporate tax paid within the bond [2]. Even when compared to OEICS and Unit Trusts, they have some disadvantages. This is because all gains are taxed as income so you cannot use your capital gains tax allowance [2] (which is £12,300 per year in the tax year 2020/21) [7].
Onshore bonds can also contain penalties if you cash them in during the first years of the policy. This is not usually the case for an ISA, OEIC or Unit Trust investment [6].
The funds available to invest in might also be limited by the insurance company providing the bond.
There might be charges to pay when you establish the bond.
What are the advantages of an onshore bond?
Onshore bonds can be useful investment vehicles for a number of reasons:
As an investment option: They offer a complementary tax efficient investment solution alongside ISAs which have investment limits. They can be more tax efficient than a general investment account but you cannot use the annual capital gains tax allowance.
One clear theme from our Family and Finances Report is that there seems to be reluctance to discuss estate planning and the passing on of wealth with children and grandchildren.
Only 50% of respondents aged 60 and above (all of whom have at least one child) said they discuss inheritance with their children; and only 35 percent have told their children exactly what their will includes.
Similarly, only 33 percent of respondents aged between 30 and 59 (all of whom have at least one living parent) know all the details about the wealth that will be passed to them.
Around one in five (19 percent) of respondents aged 60 and above say they’ve never spoken to their children about their finances. When asked why, 28 percent cited that they ‘don’t think it’s their business to know about my finances’ while 36 percent said they wanted their children to be financially independent. Some 17 percent admitted they don’t feel comfortable talking about money with their children.
As part of retirement planning: If you are a higher or advanced rate tax payer, reductions in the annual and lifetime limits can make an investment bond a very useful supplement to pensions for retirement planning.
For inter-generational planning: Depending on the type of trust you chose, onshore bonds can provide the fixed level of regular withdrawals that some trust types require to be effective, and you can keep your access to the capital and/or any income.
The decision whether to invest via an ISA, pension, or investment bond can be complicated and involves a number of factors. For that reason we recommend you speak to an expert before committing yourself to a course of action you might not be able to reverse.
This article is provided for information only. Schroders Personal Wealth does not provide managed trust services directly although we can advise on some types of packaged trusts. If a client requires a managed trust, we can introduce them to the Professional Trustee UK Trust Centre in Lloyds Bank Private Banking or to a firm of solicitors experienced in these matters. Tax planning and trusts are not regulated by the Financial Conduct Authority.
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Sources:
[1] https://www.pru.co.uk/investments/investment-articles/guide-to-investment-bonds/
[2] https://www.ftadviser.com/investments/2018/03/20/five-questions-you-should-ask-about-onshore-bonds/
[3] https://professionalparaplanner.co.uk/development/technical-9-reasons-to-use-bonds-in-financial-planning/
[4] https://adviserbusinessreview.com/why-do-onshore-bonds-seem-to-be-back-in-vogue/
[5] https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/301250/CRAG_34_April_2014.pdf
[6] https://www.moneyadviceservice.org.uk/en/articles/investment-bonds https://www.investmentsense.co.uk/technical-area/investments/investment-bonds-onshore/
[7] https://www.gov.uk/government/publications/changes-to-the-annual-exempt-amount-for-capital-gains-tax-for-the-tax-year-2020-to-2021
[8] https://www.sense-extranet.co.uk/news/round-previous-years/round-up-2016/july-2016/27th-july/taxation-of-investment-bonds-in-trust-does-the-type-of-trust-make-any-difference/
[9] https://techzone.adviserzone.com/anon/public/investment/Taxation-of-bonds
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