Tax-efficient ways to cash in an insurance bond

Insurance bonds are popular investments, but if you pay tax at higher rates when you encash them it can result in a large tax bill. The good news is there are simple and legitimate tricks you can use to avoid that. How do they work?

Tax bill

Insurance company bonds are long term and potentially tax-efficient investments. There’s no tax to pay on the bond as it increases in value. It’s only taxed when you encash all or part of it. Even then as long as you don’t withdraw more than 5% of your original investment there’s no tax to pay. The trouble is that whatever you take above the 5% added to your taxable income for the year, which can result in a large tax bill.

Example: Jan invested £30,000 in a bond in 1998. In July 2016 when she cashes it in it’s worth £85,000. This growth in value of £55,000 is added to her other income for 2016/17 and taxed accordingly. The £55,000 is treated as having been taxed at the basic rate of 20% meaning she receives a credit of £11,000 against her tax bill. However, as she’s already well into the 40% tax bracket that means she’s still landed with £11,000 tax to pay on the bond (£55,000 x (40% – 20%)).

Top slicing relief

HMRC allows a reduction in the tax bill related to encashing a bond if you’ve had it for two or more years. This is called top slicing relief (TSR), but it’s only given where the money you receive pushes you into a higher tax bracket. As Jan from our example was squarely in the 40% bracket to start with, TSR is no help to her.

Segmented bonds

Often bonds are sold as “segmented policies”. This means they are set up as multiple smaller investments instead of one large one. So Jan’s original investment could have been 30 investments of £1,000 rather than a single bond of £30,000. That would have meant she could encash a few of the segments at a time. The trouble is that that wouldn’t have helped her either. Each segment would still have triggered a higher rate tax bill for which TSR would not have been effective.

Assigning a bond

One way to use a bond tax efficiently is to assign it (transfer the rights) to someone you want to have the money and whose income is only sufficient to make them liable to basic rate tax.

Tip 1. Assigning all or part of a bond to, say, a son or daughter aged 18 or over to fund them while at university or for a deposit on a home, means they can cash in a bond with the likelihood that it will result in little or no tax liability.

Tip 2. The bad news is that Tip 1. isn’t of any use if you need the money yourself. However, if you have a spouse or unmarried partner who is a basic rate taxpayer you can assign all or part of a bond to them to encash, again resulting in little or no tax.

Tip 3. If Tips 1 and 2 don’t work for you, but you’re a director of your own business, you can defer salary and dividends from your business so that your income falls well within the basic rate band for the year in which you want to encash the bond. This could reduce the tax on the bond without increasing the tax on your salary/dividends you defer.

If your spouse or partner pays tax at lower rates than you, assigning (transferring) the bond to them will reduce the tax, possibly to nil. Alternatively, if you can reduce your income and therefore your tax rate for a year, e.g. if you’re a director you could defer salary and dividends, you achieve the same result.

Example: Assignment of Investment Bond

Assigning all or part of a bond to, say, a son or daughter aged 18 or over to fund them while at university or for a deposit on a home, means they can cash in a bond with the likelihood that it will result in little or no tax liability.

Example: Mary invested £20,000 in an insurance bond in 2001. In 2016 the bond is worth £38,000. Mary assigns the bond as a gift to her son James, who is 18 and just started university. James encashes the bond and receives £38,000 of which £18,000 counts as a taxable gain. James’ only other income for 2016/17 is some earnings from a part time job. His tax position is as follows:

* This tax is notional and therefore not refundable.