Investment bond - undercover tax trap?

Investment bonds

Insurance company investment bonds are very popular, especially in retirement as they allow you to withdraw your capital in equal, tax-free instalments of up to 5% each year. For example, if you invest £100,000, you could draw down £5,000 per year tax free, and behind the scenes your money is invested and hopefully increasing in value. Unlike with bank interest or dividends, the return on your investment isn’t taxed on an ongoing basis. Instead, the growth is taxable in the tax year in which you encash it. This can be as a full or partial surrender of the bond.

Income not capital gains

There are several quirks when it comes to the taxation of investment bonds, which is why this area is not well understood. One of the quirks is that when you cash in your investment, the gain you make is subject to income tax rather than capital gains tax.

Surrender

When you fully surrender a bond any growth in value since you purchased it counts as taxable income in the year of surrender. Amounts you received for partial surrenders are included, arriving at the total taxable amount.

Example. Sue invested £50,000 in a bond in June 2006. She has received £2,500 per year for 19 years on which she’s paid no tax because of the 5% allowance. She fully surrenders the bond in March 2026 for which she receives £36,000. The taxable gain on the bond is £33,500 (£36,000 full surrender + £47,500 partial surrenders - £50,000 original investment). The whole amount is taxable as income in 2025/26. Because of her other income when the bond money is added most of it is taxable at the higher rate.

Because the gain on the bond has accumulated over many tax years the rules allow a special tax relief. Broadly, it works out how much tax would be payable if you received e.g., 1/19th of the income in each of the 19 tax years, instead of the whole income gain in one go. This difference is called top slicing relief (TSR).

Tax on death

Another little-known quirk is that in the tax year of death all investment bonds are fully surrendered and the gains become taxable. This is the opposite of other investments, e.g. shares, whereby capital gains are wiped out on death.

This can push the deceased’s income up so much that TSR is reduced or even eliminated meaning that the estate faces a hefty tax bill. The good news is that with a little planning the tax can be reduced or avoided entirely. Consider fully surrendering one or more of your bonds to prevent the gains on each becoming taxable all at once.

Even if you only have one bond it’s probably set up by the insurance company as a series of linked smaller bonds. You can work with your insurance company to fully surrender some of the smaller bonds each year and keep your total income within the basic rate band.