Onshore bonds

Following much hype and speculation, Rachel Reeves finally put rumours to bed when she delivered her first Budget on 30 October 2024.

Changes to capital gains tax (CGT) rates and a shift in the inheritance tax (IHT) treatment of inherited pensions has left investors questioning their options.

In this article, we look at the opportunities that onshore bonds provide and why they are a serious contender for an investor’s financial plan.

Onshore bonds and General Investment Accounts

Although onshore bonds have played a part in financial planning over the years, it is fair to say that general investment accounts (GIAs) have historically been favoured by investors.

It is important to note that GIAs, however, are not protected by a tax wrapper. The underlying investments held are subject to Income Tax on any amounts of interest or dividends generated by the investments whether this paid out or automatically reinvested.

In addition, within a GIA, upon the sale of any underlying investments, any gains made will be assessed for CGT.

CGT causes misery

Over the past few years, there have been various evolutions of CGT. The CGT allowance, also referred to as the ‘Annual Exempt Amount’ (AEA), increased to a high of £12,300 in the tax year 2020/21. It remained at this level before being slashed in 2023/24 to £6,000 and reduced further to £3,000 in the current 2024/25 tax year.

Investors who use their GIA to fund their ISAs each year are finding it increasingly hard to raise the £20,000 ISA subscription without breaching the AEA. This is also the case for people wishing to make gifts to loved ones or take withdrawals for any other reason from their GIA.

Gains in excess of the AEA will result in investors paying CGT at their marginal rate. For the current tax year up until 30 October, this was 10% for basic rate taxpayers and 20% for higher rate taxpayers.

Following the Autumn Budget announcement, CGT rates have been increased with immediate effect.

As of 30 October 2024, CGT rates have increased to 18% for basic rate and 24% for higher rate taxpayers. With no change to the AEA, this increase is likely to result in GIAs becoming even less popular and the demand for onshore (and offshore) bonds set to continue.

The tax efficiency of onshore bonds

One of the key aspects of an onshore bond is that unlike a GIA it does not produce investment income.

Consequently, when it comes to dividends, taxpayers at all levels have the potential for greater tax efficiency within a bond as no tax is charged. Within a GIA, dividends above the allowance are charged at 8.75% (basic), 33.75% (higher) and 39.35% (additional) rate tax.

Non dividend income such as savings interest in a GIA is charged at income tax rates (20% basic, 40% higher and 45% additional).

Within an onshore bond, however, 20% tax is ‘deemed’ to have been paid reflecting the fact that the funds underlying a UK policy are subject to UK life fund taxation.

Onshore bonds also benefit from top-slicing relief which is designed to give relief from having a gain built up over several years from being taxed in the same year. In broad terms, the average annual gain is added to your income for the year. If the addition does not push the investor over the basic rate tax limit, then there is no further liability to either Income Tax or CGT.

Higher and additional rate taxpayers would be subject to 20% and 25% tax on any gains respectively.

Further benefits of an onshore bond

Although the tax benefits of onshore bonds are a key factor in their popularity, they also provide broader planning advantages.

Income options

Investors can withdraw up to 5% of the initial investment amount each year without an immediate tax charge. This is called the tax-deferred allowance, and it is cumulative, meaning that if the allowance is not used in one year, the amount can be carried forward to future years.

The tax-deferred allowance lets people add to their income without paying taxes right away. Instead, taxes are paid when the bond is cashed in. This is helpful for those who pay higher taxes now but expect to be in a lower tax bracket when they encash the bond.

Estate planning

Onshore bonds can be an effective tool for IHT planning. When used in conjunction with Trusts, they can help reduce the value of an estate for IHT tax purposes, potentially saving significant amounts of tax for beneficiaries.

Following the announcement that inherited pensions will become liable to IHT from 2027, this is a significant consideration for savers looking to pass on their inherited assets to their loved ones.

There is also the option to assign segments of an onshore bond to another person. Gifting part or all of an onshore bond is not considered a chargeable event, so no immediate tax is due. The recipient will be responsible for any tax on gains when eventually encashing their segments.

Flexibility

Onshore bonds offer significant flexibility in terms of investment choices and withdrawal options. Investors can switch between different funds within the bond without incurring immediate tax liabilities, allowing for strategic adjustments based on market conditions and personal financial goals.

Simplicity

Unlike GIAs, where gains need to be managed and sometimes tax paid, or loss relief claimed, the use of an onshore bond means that there is no investment income and gains to pay tax on, due to the already ‘deemed’ tax paid at source. Consequently, there may be no need for the investor to complete a self-assessment tax return.

Differences between onshore and offshore Bonds

The main difference between an onshore and offshore bond is that offshore bonds do not pay any tax at source and therefore benefit from ‘gross roll up’. This can result in potentially higher growth due to the deferral of tax. However, if a chargeable event occurs upon withdrawal, no tax is ‘deemed’ to have been paid and the gain would be taxed at the investors marginal rate of Income Tax.

Should you choose an onshore bond?

Onshore bonds can be a valuable addition to your investment portfolio, offering tax efficiency, flexibility, and potential benefits for IHT planning as well as the ability to take tax efficient income as and when required. However, it is crucial to understand the associated risks and costs, and to seek professional advice to ensure that they align with your financial goals. By working closely with your financial advisor, you can make informed decisions and take advantage of the benefits that an onshore bond can offer to enhance your overall financial plan.