Chargeable Event

cheerfulcat

With bonds you can take a natural income if you wish. Or you can take a fixed regular withdrawal. Exactly the same as ISAs and Unit Trusts.

But as I understand it the income can only be taken by encashing units ( please correct me if I'm wrong, as it would make a big difference to the argument ); that isn't what I would call natural income. When taking an income from shares or unit trusts one can take the dividends, leaving the capital intact.

It doesnt deplete capital though because it is offset by the investment return. If you assume accumulation units, the income from the underlying investments are reflected in the unit price which increases over time. So whilst a regular capital withdrawal will reduce the number of units held over time, the unit price goes up with the investment return.

But the unit price can and does go down as well as up and if you have a period of negative returns - which happens pretty frequently - you need to sell more and more units to keep the same income, thus not only reducing your capital but also increasing the amount by which the remaining units have to grow.

Very similar to the person that draws a monthly amount out of their savings account but gets an annual interest payment put back in again. They are drawing their capital each month but the interest goes back in again to make up for it. The bonds are the same except the return is reflected in the unit price.

Exactly! The value of the deposit is dropping by the month, consequently every year the amount of interest gets smaller! Whereas if he took the interest, and left the deposit alone, he would ( nominally, at least ) preserve his capital.

dunstonh

But as I understand it the income can only be taken by encashing units ( please correct me if I'm wrong, as it would make a big difference to the argument ); that isn't what I would call natural income. When taking an income from shares or unit trusts one can take the dividends, leaving the capital intact.

Traditional investment bonds only allowed a fixed withdrawal on a monetary or percentage basis. You can now get them allowing natural income exactly the same as unit trust funds.

Exactly! The capital value of the deposit is dropping by the month, consequently every year the amount of interest gets smaller!

As long as the interest is higher though, it isnt a problem. Its usually a reason why it is recommended that people wait a period before commencing a withdrawal on a bond. Let it make some money first. Although a bond with an increased allocation can often help in that respect.

Here is a real example of £100k invested late 1999. Taking the last 5 years performance on a year by year percentage, going backwards it grew by 13.6%, 15.0%, 13.8%, 5.4%, 4.8%. So only one year did it fail to hit the 5% mark. So, that year would have seen the value drop a little. However, the following years so a tiny gain and then much bigger gains. As the withdrawal was 5% of the original investment, the amount being withdrawn is now lower than 5% of the current value. Therefore there is scope to provide an increase in that withdrawal periodically. Ideal for providing an increasing "income" in retirement.

cheerfulcat

You can now get them allowing natural income exactly the same as unit trust funds.

Ah, OK, that makes a big difference!

Therefore there is scope to provide an increase in that withdrawal periodically. Ideal for providing an increasing "income" in retirement.

What is the tax treatment of anything over the 5%? And what happens after twenty years of 5% withdrawals, when the whole of the original capital has been returned? Is there still an income tax advantage, or is the income now taxed in the normal fashion? Sorry about all the questions, there really is no in-depth information freely available about investment bonds.

dunstonh

What is the tax treatment of anything over the 5%?

its still treated as withdrawal of capital but triggers a chargeable event. As long as the chargeable event doesnt give rise to higher rate tax or take an over 65 year old past £20,100 income, then it doesnt matter at all. The gain is taxable as if it were an addition to the investors income tax rate, but credited with basic rate income tax having already been paid.

And what happens after twenty years of 5% withdrawals, when the whole of the original capital has been returned?

As I understand it (and you are right, there isnt a lot to tell you what happens) a chargeable gain then exists at the end of year 20.

Is there still an income tax advantage, or is the income now taxed in the normal fashion?

To a higher rate taxpayer (or borderline higher rate), you would realise the capital and start again in a new 20 year period (assuming things havent changed by then and lets be honest, they almost certainly will have - look at the changes in the last 3-5 years, let alone 20). To a basic rate taxpayer, then there is no difference although starting again would allow the figures to be reset.

The issue of a chargeable gain to a basic rate taxpayer nowhere near higher rate tax is nothing to worry about. Someone who is a basic rate taxpayer now and has a bond but may be a higher rate taxpayer next year (or in the future) would be best reviewing their options as it could make sense to come out this tax year whilst basic rate and then restart giving a new 20 year period before they move into higher rate tax. If they are going to be higher rate for more than 20 years, then there could be better ways of doing it then an onshore bond.

The following doesnt answer any of your questions really but it is a useful summary.
http://www.adviserzone.com/pdf_library/life_brief_22.pdf

and here is one on offshore and onshore versions
http://www.adviserzone.com/pdf_library/life_brief_48.pdf

oh, and for those are getting fed up with the "discussions" on Eds tax free remarks on dividends, here is a factsheet on that which backs up the comments made by the advisers on the board.
http://www.adviserzone.com/pdf_library/life_brief_07.pdf

AND... one that is relative to the subject of this thread - chargeable gains.
http://www.adviserzone.com/pdf_library/life_brief_57.pdf

cheerfulcat

Wow, dh, thanks for a very comprehensive reply! The links don't work for me right now for some reason, but I will try again later.

EdInvestor

The reason for using a 6% projection figure ( see the other thread focussing on jem's bond) might well be to cover the 20% decrease in returns from the taxation of gains within the bond.Usually 7.5% is used for modern investment projections. The reduction by 1.5% would cover the c. 20% internal tax applied to the gains within the bond.

Of course that would effectively "cap" the charges at 1% ( or even 0.5% for the more switched-on investors) , in that people might be quite seriously concerned about a 5% projected income (required every year on a 10 year investment) if their capital was not to be depleted.

They also wouldn't be that keen on a total (charges plus tax) reduction in returns of 2-2.5%.Hence perhaps all the complexities ( extra allocation rates, bid offer spread, "chargeable events" etc etc?)

It seems this could be why the bonds have this long standing reputation of having high charges.It's not in fact the charges by themselves, but the combination of the charges and the (somewhat obfuscated) tax that causes the problem.

dunstonh

The reason for using a 6% projection figure ( see the other thread focussing on jem's bond) might well be to cover the 20% decrease in returns from the taxation of gains within the bond.Usually 7.5% is used for modern investment projections. The reduction by 1.5% would cover the c. 20% internal tax applied to the gains within the bond.

I'm afraid thats incorrect. The FSA state that 4,6 & 8% should be used on all investments unless tax free in which case 5,7 & 9% should be used. Bonds are not tax free and use 6% for that reason and the tax certainly doesnt account for 1.5% of that. OEICs and UTs also use 4,6 & 8%

Investment bonds get the same tax treatment on income as unit trusts and shares for a basic rate taxpayer. However, they pay capital gains tax on growth at 20% on applicable investments within the fund. Not all investments require capital gains tax to be paid and this brings the actual taxation down a bit.

They also wouldn't be that keen on a total (charges plus tax) reduction in returns of 2-2.5%.Hence perhaps all the complexities ( extra allocation rates, bid offer spread, "chargeable events" etc etc?)

You are not measuring it correctly so that isnt a concern.

I had to remind someone in the week why their bond is 8.8% up in less than one month (invested 24th August) compared to their ISAs and OEICs which are down by just under 1% in that same period. They wanted to know why I hadnt told them to put everything into the bond as they saw that as the better performer. In the long run the ISAs should catch up and pass the percentages on the bond but the OEICs will take a lot longer if ever as the AMC on the OEICs are higher than on the bond and the taxation on the investments doesnt make enough difference.

It seems this could be why the bonds have this long standing reputation of having high charges.It's not in fact the charges by themselves, but the combination of the charges and the (somewhat obfuscated) tax that causes the problem.

Bonds used to have a high charging structure as did many products from the past. However, like unit trusts, PEPs(now ISA) and pensions, the charges have come down. You shouldnt measure modern investment products with those that were available 5 years ago let alone 10 years. Also, not understanding a product doesnt make it bad. People drive cars without knowing how the engine works.

EdInvestor

Investment bonds get the same tax treatment on income as unit trusts and shares for a basic rate taxpayer. However, they pay capital gains tax on growth at 20% on applicable investments within the fund.

I think we can agree on this.
A survey by PWC for the FSA has these figures:


UK equities

Assumed gross rate of return 5.5%/8.5%/11.5%
Additional deduction for tax in life fund 0.00%/0.58%/1.27%
Additional deduction for tax in AUT 0.00% 0.00% 0.00%

Gilts

Assumed gross rate of return 4.5% 4.5% 4.5%
Additional deduction for tax in life fund 0.90% 0.90% 0.90%
Additional deduction for tax in AUT 0.90% 0.90% 0.90%

Overseas equities

Assumed gross rate of return 5.5% 8.5% 11.5%
Additional deduction for tax in life fund 0.63% 1.32% 2.01%
Additional deduction for tax in AUT 0.40% 0.40% 0.40%


Re a life bond with a selection of funds

Our analysis suggests that the reductions in respect of tax (for life funds) from the illustration rates of 5%, 7% and 9% in current use might vary from 0.4% for the lower illustration through 0.8% for the central
assumption to 1.2% for the higher illustration.

Re a mixed unit trust ( eg a balanced managed fund)

Different rates ought to apply for unit trusts as there is no capital gains tax within the fund. A deduction of 0.4% would be appropriate for all projections.

Re overseas equities it says a reduction of 0.4% is appropriate for all growth projections in unit trusts (this accounts for the withholding tax in the country of origin) but for life funds, the deduction should be between 0.63% and 2.01% according to the growth rates. Quite a disincentive to invest in overseas equity funds I'd have thought, since you can get good overseas exposure if you choose the right UK shares.

Jake'sGran

EdInvestor wrote:

Here's a typical example of a couple of the problems with investment bonds.

1)They are opaque: people don't understand what they are investing in

2)They are very prone to misleading sales information: people think their gains are are tax free, like ISAs, when they are not.They think they are getting tax free "income", when in fact their money is withdrawn from their capital.

I am inclined to agree with Edinvestor and have never invested in Investment Bonds because of the "ifs" and "buts" associated with them. I have noticed that, often, in The Times money pages, whenever a new investment bond comes out they give it the "thumbs down".

dunstonh

The Times money pages, whenever a new investment bond comes out they give it the "thumbs down".

I have rarely seen a newspaper review a financial services product accurately regardless of the type of product. We had the Telegraph a few weeks back criticising the Sterling ISA (and rightfully so) but actually describing their investment bond (which is also a poor quality product).

I will have to remember next time that when I am about to do an investment bond that is going to help reduce the IHT bill down by £300,000 that The Times thinks thats a bad thing.