Where to invest once you have maximised pension & ISA contributions

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 pay higher rates of income tax, especially if your marginal tax rate may reduce in the future, or
• you have 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 your assets to implement your financial planning strategy through the investment accounts available.

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[v].

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, until you have withdraw the full initial contribution, 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 initial 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, and add 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 bonds 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):

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.

It is possible to access a wide range of investments through both types of account[vii]. 

It is important that you select an account provider that offers a range of assets that will enable you to implement your financial planning strategy.