Comparing Taxation of Investments: Collectives vs. Investment Bonds

12 Mar 2025

Investing can be a powerful way to grow your client’s wealth, but understanding the tax implications of the different options available is crucial. This article explores the taxation of collectives and compares it to the tax treatment of investments held within investment bonds, both onshore and offshore.

Taxation of Collectives

When you invest in collectives, the income generated from these investments is subject to income tax at your appropriate rate. This includes interest from deposits or fixed interest investments. Beyond the personal allowance, savings allowance, and the zero percent starting rate for savings income, the tax rates are as follows:

  • 20% for basic rate taxpayers
  • 40% for higher rate taxpayers
  • 45% for additional rate taxpayers

Dividend income exceeding the dividend allowance of £500 per annum is taxed at:

  • 8.75% for basic rate taxpayers
  • 33.75% for higher rate taxpayers
  • 39.35% for additional rate taxpayers

Capital gains from the disposal of investments, above the CGT annual exemption of £3,000, are taxed at:

  • 20% for basic rate taxpayers
  • 24% for higher rate and additional rate taxpayers

Taxation of Investment Bonds

Investment bonds offer a different tax treatment, which can be advantageous for investors. The key benefit is that there are no tax implications for the investor until amounts are withdrawn from the bond.

Onshore Bond: Accumulation Stage

The tax liabilities on income, dividends, and capital gains within the investment portfolio inside the bond are managed by the insurance company underwriting the bond. The life insurance company pays corporation tax on the bond's investment income and gains. The returns you see on your client’s onshore investment bond are net of this corporation tax.

  • Income and capital gains arising to the UK life policyholder fund are taxed at a rate anchored to the basic rate of taxation, which is 20%.
  • Dividends received by the UK life policyholder fund are completely free of tax.

Offshore Bond: Accumulation Stage

  • Generally, there is no tax on income or capital gains realized by the offshore life insurance fund.
  • Tax liability arises only when the investor withdraws funds from the bond.

Decumulation Stage

5 % - withdrawals on both Onshore and Offshore Bond

Investors in both UK and offshore bonds can withdraw up to 5% of the original investment tax-deferred each policy year. If the 5% allowance is not used in a given year, it can be carried forward and used in subsequent years. For example, if no withdrawals are made for five years, an amount of 25% could be taken tax-deferred at that time.

If your withdrawals exceed the cumulative 5% allowance, the excess amount is considered a "chargeable event" and is subject to income tax. The gain is added to your client’s income for the tax year in which the excess withdrawal occurs.

Onshore Bond - Taxation of withdrawals exceeding the cumulative 5%

  • The UK life fund bears tax at the fund level, so there is no basic rate liability on any gain made by the investor.
  • Therefore, the rate of tax payable on onshore bond withdrawals over the 5% tax-deferred allowance is:
    • 0% to the extent it falls within the basic rate band
    • 20% to the extent it falls within the higher rate tax band
    • 25% to the extent it falls within the additional rate tax band

Offshore Bond - Taxation of withdrawals exceeding the cumulative 5%

No tax is payable at the life fund level, so there is no basic rate credit for the policyholder.

  • Therefore, the rate of tax payable on offshore bond withdrawals over the 5% tax-deferred allowance is:
    • 0% to the extent that the gain falls within the available personal allowance, savings allowance, and zero percent starting rate
    • 20% to the extent it falls within the basic rate band
    • 40% to the extent it falls within the higher rate tax band
    • 45% to the extent it falls within the additional rate tax ban

Final encashment

When a final encashment (full surrender) of an onshore investment bond occurs, any amounts previously withdrawn tax-deferred under the 5% allowance are added back to calculate the total gain. The gain is calculated by subtracting the total amount invested (including any amounts previously withdrawn tax-free) from the amount received upon encashment. This gain is then subject to income tax at your client’s highest marginal rate.

Top Slicing relief

Top slicing relief can help reduce the tax payable on gains from investment bonds. It works by spreading the gain over the full number of years the bond has been held, which can prevent the gain from pushing your clients into a higher tax bracket. This relief is particularly beneficial for those who have held the bond for a long period, as it can significantly reduce the overall tax liability.

Remember, a bond can also be assigned to someone (e.g. a spouse or partner) whose income falls into a lower tax bracket. Additionally, it is possible to time the encashment to coincide with a lower-income year, such as during retirement. This can further reduce the tax burden by keeping the gain within a lower tax bracket.

Conclusion

Understanding the tax implications of your investments is essential for effective financial planning. While investments in collectives are subject to immediate taxation, investment bonds offer a way to defer tax until withdrawals are made. This can provide significant tax planning opportunities, especially when considering the different tax treatments of onshore and offshore bonds.