Margaret Jago discusses the benefits of investing in offshore bonds
When looking forward to retirement, savings can be accumulated in a variety of vehicles. People will of course prioritise their savings in pension arrangements, where they get tax benefits on contribution and on investment growth. They will also prioritise ISA investment, where investment growth will be tax-free. However, after using these tax efficient investments, savers might want to consider using products from offshore life companies, including bonds, and variable annuity products.
It's the tax treatment of offshore bonds that makes them particularly appealing. A bond, like every other investment apart from pension savings, is purchased from after-tax income or capital so there is no tax relief available when making the investment. However, the growth within the bond wrapper is free of ongoing income tax or capital gains tax, other than where there is irrecoverable tax on dividend income. Therefore, the growth within the bond is virtually tax free - just like pensions savings. This can be contrasted with other sources of income, such as bank deposit interest or dividends and interest from collectives, where income will be taxed at the investor's highest marginal rates as it arises despite the fact that no income is actually being taken from the investment.
The time when personal tax liabilities are likely to arise on bond investments is when value is taken from the bond. However, like onshore bonds, offshore bonds benefit from the rule that up to 5% of the original premium can be withdrawn every year for twenty years without generating an immediate tax liability. Any 5% allowances not taken can be carried forward and taken in later years. What happens is that any tax deferred withdrawals taken fall into the tax net as part of the overall growth on the bond when it is cashed in.
There are several ways in which this 5% tax deferred withdrawal allowance can be used to mitigate tax. The first is that a higher rate taxpayer might decide to take bond withdrawals within their 5% allowance rather than generating other sources of income that would be immediately taxable. The bond gain could be planned to arise in retirement when the investor was a basic rate taxpayer.
An example of this would be where an individual partially retires early - say at 60 - when they are still getting some income and are still a higher rate taxpayer. Rather than crystallising income from one of their pensions arrangements, which would all be taxable at 40%, they could take tax deferred bond withdrawals and generate the pension income but only when they are a basic rate taxpayer.
A second way in which bond withdrawals could be used to mitigate tax is where the person can generate variable income in retirement through their pension arrangements. The investor can take tax deferred withdrawals, or indeed no withdrawals - in years when a high income is being taken from the pension arrangements, and could generate taxable amounts from the bond in years when pension income being taken is lower - again taking advantage of basic rate tax.
This flexibility in tax planning with offshore bonds is assisted by another of their features - segmentation. Generally, offshore bonds will be issued not as one policy but as a series of identical policies. What this means is that when an investor wants to take proceeds from their bond they can either take a withdrawal from all segments - in which case they will be taxed by comparing the amount taken with their available tax deferred withdrawal allowance - or they can fully cash-in some of the individual segments of the bond. If they fully cash-in segments the overall gain, including tax deferred withdrawals from those segments, will be taxable. One thing the investor will have to bear in mind when deciding which result is better in these circumstances is that tax is not the only consideration - cashing in segments may also expose them to product charges. For example, any balance of the establishment charges for advice may be collected as a cash-in charge.
As well as traditional offshore bonds, investors approaching retirement might want to consider the investment versions of the 'third way' products, variable annuities. What these products do is provide the investor with a guaranteed income for life from a chosen age, likely to be at least 60, in exchange for a lump sum investment. These variable annuity contracts differ from traditional annuity contracts in that the money used to purchase the annuity does not disappear. Instead, the provider invests the money in funds chosen by the investor, and the product has a surrender value. This means that the investor can cash in the product if they want to. However, if they leave it invested they know that they will receive whatever the guaranteed income is for life - even if the value of the underlying funds drops to zero. Another valuable feature of these contracts is that the guaranteed income may be adjusted upwards if the underlying funds increase in value.
Variable annuity contracts have obvious benefits in supplementing pension income. They provide certainty of income for the long-term coupled with the possibility of passing on remaining fund values at death. The certainty of income has several advantages. It could provide confidence that funding will be in place in the event of long term care. It could allow someone to make IHT effective gifts of other assets, knowing that their income requirements have been secured from a combination of pensions and variable annuity income.
Whether recommending bonds with their enormous investment choice, tax advantages and flexibility, or variable annuity contracts offering certainty of income, advisers can make the most of products from international life companies to meet the needs of their clients in retirement.
'Recovery or boom'
Staying invested could prove lucrative
Consider lasting powers of attorney
Less environment, more governance threatens to undermine firms' green credentials