Bonds versus collectives for higher rate taxpayers

Summary

With capital gains tax of 20% at the higher rate and a 45% additional rate of income tax for those whose taxable income exceeds £125,140, advisers must consider carefully the tax benefits of onshore investment bonds for their 40% and 45% taxpaying clients.

Facts and analysis

It is important to approach the choice of investment wrapper for a particular client with an open mind and a commitment to making the decision that delivers the best outcome taking account of all the factors including (but not restricted to) fund and investor taxation.

Assuming that ISAs and pensions are always considered first, a common choice for retail investors with capital to invest is between insurance-based products and collective investments, such as unit trusts and open-ended investment companies (OEICs). There are UK and offshore versions of both. Capital gains realised from collectives (UK or reporting offshore collectives) are subject to CGT but chargeable gains realised by the investor when encashing an investment bond are subject to income tax.

Investments that allow the investor to access the CGT regime will also permit the use of the annual CGT exemption, which is £6,000 for the 2023/24 tax year. An investor will pay CGT at 10% for gains that, when added to the taxable income of the investor, fall below the higher rate tax threshold and 20% for gains that are in excess of the threshold (except for carried interest and gains on residential property which are taxed at 18% and 28%).

UK investment bonds, on the other hand, suffer a 20% internal tax on returns with a higher rate taxpayer suffering a further 20% (or 25% for additional rate payers with taxable income over £125,140) income tax charge on the profit that is made on final encashment. Offshore bonds suffer no "internal" tax but the UK resident investor will be assessed on returns with no tax credit. All gains made under offshore non reporting funds (roll-up funds) are subject to income tax on realisation. Presented like this it seems that the collective is "tax preferable". However, this analysis is too simplistic and takes no account of a number of tax and other factors that can impact on the relative attraction of the investment bond and collective.

Here are some of the key tax factors relevant for the UK resident investor:

Dividend Allowance and Personal Savings Allowance

The dividend allowance reduced to £2,000 from the 2018/19 tax year and £1,000 from the 2023/24 tax year. The government has announced their intention to reduce the dividend allowance to £500 in 2024/25.  This means that an investor doesn't have to pay tax on the first £1,000 of dividend income in 2023/24. For dividends in excess of £1,000 a higher and additional rate taxpayer will pay tax at 33.75% and 39.35% respectively.

The personal savings allowance means that a higher rate taxpayer can earn up to £500 each tax year in savings income tax free (an additional rate taxpayer has no personal savings allowance).

If income from an investment is within the dividend and/or personal savings allowances the collective will generally be the better choice on tax grounds for the higher rate taxpayer.

Capital Gains

The main factor in analysing the complete tax position is how the underlying investment growth arises. If it consists purely of capital growth and no, or little, income the collective will generally be the better choice on tax grounds especially for the higher and additional rate taxpayers. 

Reinvested Income

While the taxation of capital gains looks attractive, at a time of highly volatile asset values, many investors may consider capital growth oriented investments to carry a higher (and potentially unacceptable) degree of risk. It is widely accepted that investing for income in a portfolio that is then reinvested reduces overall risk and over the long term is an important driver of growth. In such portfolios the comparative tax position can change for the following reasons:

• Franked UK dividend income income paid to a UK insurance company suffers no further tax and can thus be fully reinvested.

• Dividend income paid to a collective will, after deduction of management expenses, generally be taxed on the investor even if reinvested. Higher rate taxpayers will have to pay an extra 33.75% income tax on the dividend income they receive in excess of their dividend allowance. For example, a higher rate taxpayer receiving a dividend of £10,000 will have a further tax liability of £3,037.50 (assuming the £1,000 dividend allowance is available and the remaining £9,000 is taxed at 33.75%) leaving a net amount of £6,962.50 available to accumulate. The same dividend paid to a UK insurance company suffers no further tax resulting in £10,000 available for reinvestment.  The tax payable on dividends from directly held collectives must be taken into account in determining net returns to the investor even though the tax is unlikely to be physically paid out of the reinvested dividends.
• In volatile investment markets, money and cash funds continue to have an appeal. Here, interest paid to a UK life fund will be reinvested after 20% tax at life fund rates. Interest distributions (from a collective invested substantially in cash, debt or fixed interest) received by a higher rate taxpaying investor will suffer 40% tax year on year for interest payments in excess of their personal savings allowance.

In summary, with all other things being equal (including product charges) for capital growth driven by capital gains a collective looks "tax best".  For reinvested income (especially for higher rate taxpaying investors) the onshore bond looks "tax best" for dividends in excess of £1,000/interest in excess of £500, but for dividends within the £1,000 dividend allowance/interest within the £500 personal savings allowance the collective looks preferable.

Next steps

There are a number of factors to take into account when comparing collectives and investment bonds for higher rate taxpayers so'one size' definitely 'doesn't fit all'.

It is essential to say that it is not all about "the numbers". There are other important factors that can influence the most appropriate wrapper choice.

Factors such as:

• The regular use of the annual CGT exemption, dividend allowance and personal savings allowance.
• Encashment strategies for bonds and collectives - possibly involving assignment which is usually tax free with a bond if assigned as a gift.
• Administrative simplicity - again this usually favours the bond.
• Investment switching - with no tax consequences under a bond.
• The fact that on the death of the holder of a collective its cost value will be re-based to that at the date of death so that all accrued unrealised gains to that point will be "wiped" out.
• The impact of charges under the ‘competing’ products.
• In some cases it may be that the desired underlying investment is only available through one or a restricted number of investment wrappers.

In summary, tax, charges and choice of underlying investment together will influence the choice of wrapper on financial grounds. We have deliberately given greatest attention to tax in this article.

Where "non-financial" benefits like administrative simplicity or ease of holding in trust are delivered by a product that does not seem to provide the optimum financial return the difference in expected financial return will represent the "price" for these benefits and the investor will have a clear "cost/benefit" decision to make.

Especially for bigger investments it is essential that all the factors that affect decision making are taken into account when making a recommendation. Not to do so can seriously affect the returns that the investor receives.

Important information

This information has not been approved for use with customers and is based on Aviva’s interpretation of current law and legislation, and our understanding of HM Revenue & Customs (HMRC) practice as at 6 April 2023. It is provided for general information purposes only and should not be relied upon in place of legal or other professional advice. Both the law and HMRC practice will change from time to time and our interpretation may be subject to challenge by HMRC or other regulatory body. Aviva cannot act as legal adviser for you or your clients. You should always seek appropriate legal or other professional advice.