Wrappers Unwrapped 2: Investment Funds vs Insurance Bonds

5 min read 28 May 21

Investment funds and insurance bonds, are both mainstays of financial planning. But their different features and tax treatment means their suitability for clients can vary. Below we detail the tax treatment of both and, below, outline circumstances when each may be appropriate.

Investment Funds
(OEICs, unit trusts)
Insurance Bonds
(Onshore and Offshore)
Gives exposure to a pooled, professionally-managed investment portfolio Gives exposure to a pooled, professionally-managed investment portfolio
Wide range of strategies available Wide range of strategies available
No life insurance element Includes a life insurance element
Can be held in an ISA or SIPP Cannot be held in an ISA  or SIPP – but offshore versions are available
Can be held indefinitely and redeemed at any time May have a minimum term

Some of the tax benefits of investment funds

  • If a client has their capital gains ‘Annual Exempt Allowance’ to use up, gains from investment funds can be set against it. Gains on insurance bonds can’t.
  • If a client hasn’t used up their Starting Rate for Savings/Personal Savings Allowance, some/all of the interest on an interest-distributing fund may be tax free.
  • If a client hasn’t used up their annual dividend allowance, up to the first £2,000 a year from a dividend-distributing investment fund may be tax free.
  • Some of the tax benefits of insurance bonds
  • If an income-seeking client has used up their personal and ISA allowances, the 5%pa ‘tax-deferred’ allowance on insurance bonds can help generate a tax-efficient income.
  • If a client hasn’t used up their Starting Rate for Savings/Personal Savings Allowance, some/all of gains realised on an offshore bond may be tax free.
  • If a client wishes to pass on wealth, heirs can be included on investment bonds as ‘lives assured’, allowing bonds to be inherited on death without a taxable ‘chargeable event’.
  • If a higher or additional tax-rate payer expects to become a basic-rate taxpayer at a later date, the ability to defer withdrawals on an insurance bond may be beneficial.

Investment Funds (OEICs, unit trusts held outside of an ISA)

Internal tax treatment:

  • Interest and rental income subject to corporation tax at 20%1
  • No corporation tax to pay on dividends or capital gains within the fund

External income tax treatment

Applies to both accumulation and income shares:

  • On funds distributing dividends:
  • Dividends now paid gross
  • First £2,000 tax-free if dividend allowance available
  • Thereafter taxed at basic (7.5%), higher (32.5%) or additional (38.1%) rates
  • On funds distributing interest2:
  • Interest now paid gross
  • Starting Rate for Savings and Personal Savings Allowance allows some interest to be tax-free – will vary with holder’s tax rate/income
  • Interest then taxed at basic (20%), higher (40%) and additional (45%) rates

External capital gains treatment

  • Sales and disposals of shares subject to capital gains tax (CGT), with gains calculated on an average cost basis.
  • Switches between share classes in same fund not treated as a disposal for CGT
  • Tax only payable if gains exceed the Annual Exempt Amount of £12,300
  • Gains then taxed at the basic (20%) or higher (40%) rate

Tax treatment on death

  • Investment funds included in an estate for inheritance tax purposes unless held in certain trust arrangements

Insurance Bonds (Onshore and Offshore)

Internal tax treatment

Onshore bonds: Same as investment funds (left) plus 20% corporation tax also payable on realised capital gains

Offshore bonds: Usually registered in a tax-favoured jurisdiction, enabling  ‘gross roll-up’ of gains and income3

External income tax treatment

Gains on bonds only subject to tax on the following ‘chargeable events

  • Full surrender of the bond
  • Part-surrenders in excess of 5%pa of the original premium
  • Transfer of legal ownership in return for money/money’s worth
  • Maturity of a capital redemption bond
  • Death of the last life assured

Rates of tax charged

Onshore bonds: Gains treated as the highest slice of income and the tax rate will depends on the marginal rate they push the holder into: basic (0%4), higher (20%) and additional rate (25%)

Offshore bonds:  Gains treated as savings income and can be set against the Personal Allowance, Savings Starting Rate and/or Personal Savings Allowance where available. Then taxed at basic (20%), higher (40%) or additional rate (45%)

External capital gains treatment

Profits on insurance bonds are not subject to capital gains tax – only income tax, as above.

Tax treatment on death

  • Gains taxed as above only on death of last life assured.
  • Capital redemption bonds can be passed on without a chargeable event

Notes:

1 - To avoid double taxation, if a fund is interest-distributing, gross interest distributions are relievable as an  expense against the fund’s income 2 - To qualify, 60% of more of the fund’s market value must be invested in interest-yielding assets – e.g fixed-interest bonds and cash deposits 3 - Withholding tax may be deducted at source and cannot be reclaimed 4 - Reflects that corporation tax is paid internally