Life insurance policies are sometimes referred to as investment bonds where a lump sum of money is invested in a variety of funds. The bonds can be for a fixed term or they are on-going without a set term. At the maturity of an investment bond or when you decide to cash it in, the amount you receive will depend on how well or not the investment has performed.
Other names for Investment Bonds are Insurance Bonds, With-profit Bonds, Unit-linked Bonds and Single Premium Bonds.
Are investment bonds right for you?
To invest in investment bonds, you will need a lump sum of at least £5,000 that can be invested for a period of five years or more.
There is no guarantee that the investment will grow. Depending on how the fund performs the investment can do down as well as up, so you may get back less than you put in.
How they work
A lump sum of between £5,000 to £10,000 is usually invested into a whole of life investment bond. This type of bond doesn’t usually have a minimum term, but there may be penalties for terminating in the early years.
There is a choice of where the lump sum can be invested in. You can either find a fund yourself, if you are comfortable with making investments or an Independent Financial Adviser (IFA) can advise you.
The investment bond will pay out a lump sum on death or surrender of the bond. How much is paid out depends on the terms and conditions of the bond and how the investment performs. If the investment is not a whole of life bond, it will be paid out at the end of the term.
There are some investment bonds that guarantees the capital you paid in. Such guarantees involve a counterparty who will bear the risk of any failure if the investment bond fails to make a profit.
Types of funds
There are two types of funds in which your money can be invested in: with-profits or unit-linked.
The tax rules are the same for both types of funds. Tax is paid by the insurer on the growth and the income accrued in the fund.
What are the risks and returns?
As briefly mentioned before some investments will offer a guarantee that the capital invested will not be affected if the investment performs poorly. You will get back what you put in.
If you choose a bond where a variety of investment funds can be invested in and funds can be switched easily, any fluctuations in the market can be tolerated better.
As the investment has an element of life assurance, the investment bond policy may pay out a little more than what the fund is worth, if you die mid-term.
Accessing your money
It is best to leave your money invested for the term of the bond. However, if you need access to the money you can withdraw all or some of the money, but a surrender penalty may be payable if this happens in the first few years. You may also have to pay tax on what you’re taking out. If you think you may need to access your money early, this may not be for you and consider alternative investments.
If you need access to your money, investment bonds do allow you to make withdrawals each year up to a specified amount – usually 5% of the sum invested. This can be withdrawn without causing any immediate tax liability. However, the tax will have to paid when the bond is eventually cashed in. Any withdrawals will be added to the profit made, if any, and taxed as income for that tax year.
Check to see what the policy conditions state to work out any charges that may be applicable to full or partial withdrawals.
Fees and charges
Insurers normally have a charging structure, so it is important to understand how you will be charged:
- There may be initial charges to pay when taking out the bond.
- Bonds that guarantee you won’t lose any of your capital may attract more charges.
- To switch between investment funds with the same insurer doesn’t cost anything, but if you switch often, you may be charged.
- A charge may become payable if you cash in the bond in the first few years.
How safe is investing in bonds?
Investing in investing bonds is generally safe and your money is secure. The only exception if is the insurance company goes bust, but this rarely happens.
Should this happen compensation is not payable as the value of the investment falls.
Paying tax on investment bonds
All income and gains made from an investment bond are taxed at 20% and paid out of the investment bond directly.
You can withdraw a maximum of 5% per year for up to 20 years without triggering extra tax charges.
For any year that you do not use your 5% allowance, this can be carried over to the next year. For example, if you do not withdraw any funds in year one, you will have the ability to withdraw up to 10% in year two without incurring any tax liability.
For higher rate / additional rate taxpayers who pay 40% or 45% tax in any one year on income, having an investment bond can reduce your income tax bill.
The tax liability won’t disappear, but it will be deferred and addition tax due will then be paid when the bond is cashed in or on maturity.
Even though you will have paid 20% income tax on your earnings, there may be additional income tax to pay should any gains push your income over the higher or additional rate tax threshold in the year of maturity. Therefore, any capital gains are treated as income and is liable for tax.
There is a way of possibly avoiding this. A method called ‘top slicing’ can be used where the overall profit of the bond is divided by the years the bond has been held, this will include any withdrawals during that time. If the final figure after this calculation when combined with your other income for the tax year is less than the higher-rate tax threshold, you will not have to pay any extra tax.
On the other hand, if the profits using this method means that your gains are over the higher rate tax threshold for that year, extra tax is payable on the whole sum gained.
Where can I get investment bonds?
Investment bonds can be bought from an insurance directly or through a financial adviser. For further information about investments bonds and if they are the right option for you contact an IFA.