When it’s time to encash your investment bonds, how much you get back depends on how your investment performed and your tax liability. Investors should take care when encashing (making withdrawals) from these investments to avoid unexpected tax bills.

There are lots of terms around bonds which can be confusing for new investors – such as surrender values and maturity dates. Fortunately for our clients, we work hard to make financial planning simple. If you’re thinking of encashing all or part of an investment bond, a Wren Sterling adviser can help you make the most of your investment – especially where large gains are made. This article answers some of the questions we’re often asked about investment bonds.

What is an investment bond?

An investment bond is a single-premium life insurance policy that can be used to hold investments in a tax-efficient manner. How these funds are invested will depend on your preferences when you set up your account.

There are several other types of financial products which may have ‘bond’ in the title, but behave very differently.

How is a bond different from an investment bond?

Bonds are loans made to governments or large businesses for a set time. When you ‘cash in’ your investment bond, how much you will get back depends on how the investment has performed. Investment bonds usually pay investors interest to compensate them for this loan. This interest  based on a fixed rate, and is usually paid twice a year.

What is a premium bond?

You may have heard of premium bonds – but these are not the same as investment bonds. Unlike other types of bonds, which earn interest or regular income, investors with premium bonds are entered into a monthly prize draw. While there are different types of bonds, in this article we’re going to focus on investment bonds.

When should I cash in my investment bonds?

Your investment bond will ‘mature’ when you pass away, and run until the death of all persons assured (or for a term up to 99 years for a capital redemption bond.)

• You pay a surrender fee to withdraw your investment.
• Your bond matures.

If your circumstances change you can withdraw small amounts from your bond each month or each year, or you can fully encash your policy. How this is taxed will depend on the size of your withdrawals. If you take less than 5% pa, tax deferred withdrawals can continue until all of the investment amount has been withdrawn in this way.

Whether or not you should cash in your investment bond will depend on your circumstances and your tax liability, as your gains may be liable to income tax. A financial adviser can help you calculate this to ensure you’re not losing out.

Can I cash in part of my bond?

Any “part surrenders” will also have an effect when calculating your gains. For this article, we’re going to focus on encashing the whole policy (or policy segment), as the basic premise is the same.

Depending on the type of bond you choose, there will be differences. You should always look at policy conditions to find out what charges might apply to withdrawals. For example, the main difference between onshore and offshore bonds is their tax treatment. If you are thinking of making an investment please speak to your financial adviser, as there will be more to consider than is discussed within the scope of this article, which focuses on onshore bonds.

How will I be taxed?

When fully surrendering the investment bond, the “chargeable event” (where any gain may result in a tax liability) is treated as having happened on the day it is surrendered – and your gain is considered as income for that tax year.

There are a number of events which may trigger chargeable events, such as:

• Transferring ownership of all or part of the bond.
• Encashing all or part of the bond.
• The death of the final life assured.
• The maturity date (some investment bonds may be subject to this).

How do I calculate my overall gain?

When encashing bonds, the taxable part of your investment is the overall gain. To find out what this is, you add the surrender value (the amount your bond is worth at the time of encashment) and any previous withdrawals, then deduct the payments you have made to the bond, as well as any gains over the five per cent allowance.

Let’s use an example. Harry has a taxable income of £21,000, which is within the basic tax band. Harry has decided to encash his investment bond, which has gained £7,000 in value. This means there is no additional tax to pay.

Any tax liability is calculated based on the overall gain made on the investment bond – not on the amount invested. As Harry’s gain did not increase his tax liability, this was a simple calculation. However, if this gain had caused Harry’s income to increase, we would need to calculate the top-slicing relief.

How will I be taxed if I am a high or additional rate tax payer?

You will only pay tax on the overall gain if you already pay higher rate Income Tax, or if the top-sliced gain takes your income into the higher rate band. You will then pay 20 per cent or 25 per cent tax on the gain, or part of the gain. This is because an onshore bond is effectively taxed at 20 per cent at source.

As an example, Lynne encashes her bond which she has held for just over 7 years causing a chargeable event gain of £7,000. Her other income for the same tax year is £48,000. Before adding the gain, Lynne’s taxable income is below the higher rate tax limit, but with the gain, Lynne’s total income for that year will fall into the higher rate bracket. This means that Lynne could benefit from top-slicing relief.

How does top-slicing work?

Top-slicing relief can reduce the tax payable on gains from a bond – particularly by those whose tax liability may cause them to be lifted into the high rate tax bracket by their investment gains. When an investment bond is encashed, the investment gain is divided between the number of whole years the policy has been held, called ‘top-slicing’.

The full gain is added to income when working out adjusted net income, i.e. to see whether there is loss of personal allowance, personal savings allowance, child benefit etc, so even if there is no tax on a bond due to top-slicing relief, there can still be an indirect tax effect.

Lynne has held her bond for seven years. As her overall gain is £7,000, the sliced gain is £1,000. The full gain may affect tax on her other income – even with top-slicing relief. In this example there is no tax on the bond gain itself.

If you’re thinking about encashing all or part of your bond, we’d recommend talking to an Independent Financial Adviser to help you work out your tax liability, and ensure that you’re not paying more tax on your investments than you need to.

At Wren Sterling we take the time to get to know you before we make any recommendations – your personal circumstances, your investment goals and your level of risk. Our on-going clients can benefit from regular reviews, keeping your financial plans on track in the face of life’s opportunities and challenges.

The Financial Conduct Authority does not regulate taxation advice, the levels, bases and reliefs from taxation are subject to the individual circumstances of the investor. The value of your investment can fall as well as rise and is not guaranteed.