Life insurance investment bonds

Investment bonds are a type of policy that can be used to grow your savings, or initial investment, over a prolonged period of time, offering valuable tax planning opportunities. They can be tax-efficient investment options, potentially allowing for tax free growth and an alternative to traditional term life insurance policies, especially if you have several thousand pounds right now you want to grow.

However, as with all investments, performance can vary. The value of your investment bond can go down as well as up — although some policies will guarantee the return of your initial investment following your death. These are sometimes referred to as capital redemption bonds, which can trigger a chargeable event, resulting in a tax liability when the bond is cashed in or a significant withdrawal is made.

There’s ultimately more risk and uncertainty involved with an investment bond than a traditional life insurance policy, but they offer tax planning opportunities, flexibility, and the potential for high returns, making them an appealing alternative for some investors.

There are two types of investment bonds, based on the way the money is invested. They come with different levels of risk and potential for return.

• Onshore bonds – Issued by UK-based life insurance companies, these are subject to UK corporation tax at 20%. However, investors do not pay income tax or capital gains tax on any growth within the bond. This provides a clear tax treatment benefit compared to a general investment account.
• Offshore bonds – Offshore bonds are based in tax-efficient jurisdictions and allow for tax-deferred withdrawals and sometimes reduced withholding tax rates. However, UK tax may still be payable on any gains when you withdraw money.

Additionally, bonds can be structured as:

• with-profits: benefits are indirectly affected by investment performance. This is the most common type of investment product sold by insurance providers. The initial sum assured invested is topped up annually by bonuses, based on the performance of the investment.
• unit-linked: benefits are directly affected by investment performance. The single payment premium buys units in the fund of the investor’s choice. The policy’s value depends on the performance of the fund, or funds, to which it is linked. These policies come with the potential for higher rates of return, but a collapse in the value of the fund could wipe out your investment and any potential payout after your death.

Some investment bonds offer capital guarantees, ensuring that you won’t receive less than your original investment. However, these may come with higher provider fees and different tax treatments.

Unlike term life insurance, with investment bonds you can access some of your money during your life. Most allow for tax-deferred withdrawals of up to 5% of the original investment annually, for up to 20 years, which may include dividend income. This means you can withdraw money gradually without immediate tax implications.

Unused withdrawal allowances can be rolled over to future years. For example, if you make no withdrawals for two years, you may withdraw up to 15% in the third year. This helps manage taxable income across tax years.

However, that tax liability doesn’t just vanish. A chargeable event occurs when the bond is cashed in, and any chargeable event gain (including previously deferred amounts) is added to your income for that tax year. You may qualify for top slicing relief to reduce the total tax liability.

Attempting to withdraw money early may result in surrender penalties, and if your yearly withdrawals exceed the growth rate, you could erode your investment.

On top of the initial investment deposit, you may face charges at the outset of the policy and throughout. For years, investment bonds were criticised for their excessive fees, but their charging structure has changed in recent years to make them more attractive investment vehicles and life insurance alternatives.

But you will still face fees to the insurance provider, which may include:

• charges when you take out the bond
• higher initial charges if you opt for a bond that guarantees your initial investment
• early surrender penalties if you want to withdraw money within the first few years
• Ongoing fund management fees

Investment bonds offer numerous tax planning opportunities, including considerations for the actual tax paid upon withdrawal.

• Investment income within the bond is taxed at the life fund level (20%) and is not subject to basic rate tax again for basic rate taxpayers.
• Capital gains tax does not apply to growth within the bond.
• You may avoid an immediate tax charge through tax-deferred withdrawals.
• Chargeable event gains are taxed as savings income, potentially benefitting from your personal savings allowance and top slicing relief.

Offshore bonds may defer tax longer but could face a higher tax burden when you cash them in. Onshore bonds may be simpler for those who’ve already paid basic rate tax or are in the basic rate tax band.

Assigning a bond to someone else, or allowing it to be redeemed after death, can reduce inheritance tax and capital gains exposure — especially if you’ve already used your capital gains tax allowance.

While these can be efficient tools, the tax rules surrounding onshore and offshore bonds are complex. Taxation is typically based on your highest marginal tax rate, so it's wise to consult a financial adviser to fully understand your position.

The investments within a bond can either be actively managed or passively tracked, depending on the provider and policy type. Actively managed funds aim to outperform the market by leveraging the expertise of professional fund managers and may include offshore bond investments, while passive funds simply mirror market indices like the FTSE 100, potentially becoming a non income producing investment.

Choosing between active and passive management can impact your fees and returns. Active funds often charge higher management fees, but may outperform in volatile markets. Passive funds tend to have lower fees and suit investors looking for long-term growth without the cost of active oversight.

Investment bonds may be suitable if:

• You’re a basic rate taxpayer and want to benefit from tax-deferred growth
• You want to supplement your income through 5% annual withdrawals
• You’re planning for inheritance tax mitigation via trust-based structures
• You want to grow your money without worrying about capital gains tax
• You're open to some investment risk in exchange for potential higher returns

Investment bonds are less suitable if:

• You’re in a higher tax bracket and likely to face a large tax charge when cashing in
• You require guaranteed returns with no exposure to market volatility
• You need short-term access to your funds without early withdrawal penalties
• You prefer low-fee, DIY investment options like ISAs or general investment accounts

Investment bonds are best viewed as a long-term tax planning and estate management tool, rather than a short-term savings vehicle. Withdrawals and gains can still be subject to income tax.