Hegarty Wealth

Summary

You should read this article if the ISA and pension allowances are not sufficient to meet your savings needs due to high earnings, or high liquid asset balances from accrued surplus income or a capital windfall.

In the article we compare the taxation, fees, investment options, and investor protection for the two main investment account options[i], namely:

Taxable investment accounts (sometimes called a general investment account) - This is any investment account that does not attract special tax treatment. These accounts could be offered by banks, asset managers, stockbrokers, or ‘investment platforms[ii]’.

Offshore bond accounts - While in this article we have used the term ‘account’, as they operate like accounts on a day-to-day basis, offshore bonds are insurance contracts[iii] offered by insurance companies usually based in the Isle of Man or Ireland. Like an account, the value of the insurance contract is equal to the value of the investments you purchase with your contribution(s).

Generally, the tax deferral and flexibility offered by an offshore bond account may provide long-term tax benefits over a taxable investment account if you have:

high taxable income, especially if it may reduce in the future, or
high allocations to liquid assets that generate taxable income.

You should also ensure:

the investments available to you in your chosen account will enable you to implement your financial planning strategy efficiently.
the account fees represents good value for you.
you understand the risks that apply.

A good independent wealth adviser will advise you on how to optimise the assets you need to hold to implement your financial planning strategy through the investment accounts available.

Taxation

Taxable investment account

Income from your investments is taxable in the year it arises, whether you receive it or not. Capital gains arising from the disposal of your investments are taxable in the year of disposal.

Your investment income and capital gains are added to your other income in a prescribed order, and you pay tax[iv] depending on your marginal rate of taxation and the type of income.

The table below summarises the tax rates that apply to the different types of investment return.

Offshore bond account

Investments held within the account grow virtually free of tax.

You pay tax on any ‘chargeable gains’ (increases in the account value, accounting for any withdrawals) only when a ‘chargeable event’ occurs, for example on encashment or partial encashment.

The ‘chargeable gain’ is classified as savings income and is taxed at the rates shown for interest income in the table above.

The key differentiating tax features of offshore bond accounts for UK residents are:

Tax deferral - You do not pay tax until a chargeable event occurs.
5% cumulative withdrawals - You can withdraw up to 5% of your contributions each year without creating an income tax liability. The 5% allowance is cumulative, for example, if you contribute £1,000,000 and do not make any withdrawals in the first three years, you can withdraw up to £200,000 (20% of the contribution) in the fourth year. After 20 years, you can withdraw the full value of the contribution.
Top-slicing relief – Broadly, top-slicing relief enables you to divide a chargeable gain by the age (in full years) of the offshore bond before adding the ‘top-sliced gain’ to your other income to determine your marginal rate of income tax (though the whole gain is taxed).
The ability to assign – In general, you can transfer assets, including those held in a taxable investment account, to your spouse and to certain trusts without liability to capital gains tax. Offshore bond accounts are even more flexible as you can also assign all or part of the account to other family members without liability to tax.

The ability to defer tax through an offshore bond account can enhance net returns as you benefit from compounded returns on investment returns that otherwise would have been used to pay tax earlier in a taxable investment account. The longer the period of tax deferral the greater the benefit. The 5% cumulative withdrawals enable you to defer tax for longer, by allowing you to access your original capital before requiring you to create a chargeable event to access funds.

In addition, you may be able to defer tax to a time when your marginal rate of income tax is lower, for example after you have retired.

Top-slicing relief and the ability to assign part of the offshore bond account to lower rate tax paying family members like your spouse, children, or grandchildren, may enable you to pay lower rates of tax on larger gains.

Comparison - Interest / income producing investments

Assets such as cash and fixed income investments, that provide most of their returns in interest / income, are taxed at the same rate in an offshore bond account and a taxable investment account. Therefore, the tax deferral through an offshore bond account often makes them efficient.

The following chart[vi] shows the change in the real value of £1,000,000 after taxes and invested with an income return of 4% pa (net of fees):

Tax efficient investment | offshore bond | Independent financial advice | fixed fee financial advice

The difference between the top and bottom lines highlights the potential benefit an offshore bond account can offer over a taxable investment account if you are a higher or additional rate taxpayer that owns interest / income producing assets, but you (or someone you can transfer the offshore bond account to) may be a basic rate taxpayer in the future. i.e. you could defer paying tax at 40% / 45% each year on the income produced by your investments, and instead pay tax at 20% on the chargeable gain in the future.

Comparison - Capital gains and dividends

Tax rates on dividends and capital gains from assets held in a taxable investment account are lower than the rates that apply to the chargeable gains on an offshore bond account. Therefore, for assets that produce gains or dividends such as company shares, you should consider the tax deferral available from an offshore bond, against the lower rates of tax that apply in the taxable investment account (noting that capital gains also benefit from tax deferral until an asset is sold).

The following chart[vi] shows the real value after taxes of £1,000,000 invested in a portfolio of company shares returning 7% pa (net of fees):

If you are likely to be a basic rate taxpayer in the future, the offshore bond could remain attractive for holding company shares. However, if you are likely to be higher or additional rate taxpayer and cannot assign the offshore bond to a basic-rate tax paying spouse (or other family member) then, in this example, it takes over 30 years for the offshore bond to be a more efficient account when holding company shares.

Taxation summary

To ascertain the optimal account, you should consider the following in the context of your overall financial planning strategy.

Your investment time horizon.
Your own and your family members' current and future marginal tax rates.
The return characteristics of each of the assets you intend to hold. It is possible that using both types of account may be appropriate.

Fees

Account providers offer a surprisingly wide range of terms for both taxable investment accounts and offshore bond accounts so ensuring you select an account that offers good value to you can have as much impact as taxation.

Taxable investment account

Most investment platforms charge an annual percentage fee, perhaps in the range of 0.05% to 0.30% (lower for larger investments). Some account providers will cap their fees in nominal terms when they reach a certain level.

Offshore bond account

Most offshore bond accounts have an annual fixed fee, perhaps in the range of £500 to £1,000 pa, and an initial percentage fee, perhaps in the region 0.5% to 1.5% (lower for larger investments). Some investment platforms offer offshore bonds and charge similar fees to their taxable investment accounts.

Implications

Generally, for both taxable investment accounts and offshore bond accounts, larger accounts attract lower fees relative to the size of the account.

For smaller accounts, fixed fees can have a significant impact on returns and therefore many offshore bonds account fee models may not be appropriate. However, fixed fees are often favourable for larger accounts (for example, £1,000 pa is 0.5% pa of an account balance of £200,000, but 0.05% of £2,000,000).

Asset ownership and investor protection

Taxable investment account

Assets you hold in a taxable investment account are ring-fenced and owned by you as the account holder.

Many investments are protected by the Financial Services Compensation Scheme up to a value of £85,000 per investment provider. The protection does not apply to the investment returns, but in the unlikely event that the investment provider became insolvent and for some reason (for example fraud) your assets were unavailable to you.

Offshore bond account

An offshore bond holder owns the contract of insurance, but the insurer (the account provider) owns the underlying assets, which they use to pay the policyholder when they withdraw from the account. The insurance company is required to ring-fence policyholder assets from their own.

If the assets were not available to pay your account balance on withdrawal, you may be protected by the investor protection scheme in the jurisdiction that the account is located. For example, the Isle of Man policyholder protection scheme should protect up to 90% of the value of the policy.

Notes:

[i] Other investments such as Venture Capital Trusts, Enterprise investment Schemes and Private Equity funds offer tax incentives and / or diversification benefits, though may be high-risk and / or illiquid, and or not considered in this article, though we would be happy to discuss them with you.

[ii] Investment platforms offers access to a wide range of investments through personal pensions, ISAs, and taxable investment account. Some also offer access to offshore bond accounts.

[iii] You can establish an offshore bonds on a life-assured basis with a nominal amount of life cover (e.g., 1%), or on a capital redemption basis, with some nominal fixed future value (usually at the end of a 99-year term).

[iv] There are annual allowances for individuals to earn small amounts of dividend (£500 from 6 April 2024) and savings income (£0 to £1,000 depending on your total income), and to realise small amounts of capital gains (£3,000 from 6 April 2024) without paying tax. Those with lower incomes may also be entitled to a starting savings rate band of 0% on up to £5,000 of savings income over the personal allowance.

[v] The personal allowance is tapered away for individuals with income over £100,000, and is not available to those that claim the remittance basis of taxation. Higher rates of capital gains tax apply to residential property and carried interests from private equity funds.

[vi] Income at 4% pa after fees. Company shares total return of 7% pa, comprising a 2% dividend yield and 5% capital growth with portfolio turnover of 10% pa. Inflation at 2.5% pa. Returns reinvested. The value shown is after tax if the investments in the taxable investment account are liquidated, or the offshore bond is encashed.

General:

This article is a summary of the main differences and key considerations when selecting between an offshore bond account and a taxable investment account. We have simplified many of the areas for brevity.

Before you invest in any type of investment or account, you should obtain personalised advice from an independent financial adviser.

You risk losing capital when you invest.

Any reference to legislation and tax is based on our understanding of UK law and HMRCs practice at the date of production. These may be subject to change in the future. Tax rates and reliefs may be altered.

Where to invest once you have maximised pension & ISA contributions

Summary

Taxation

Fees

Investments

Asset ownership and investor protection

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