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Where should you invest after maximising pension and 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
  • You have significant cash and investment balances from accrued surplus income or a capital windfall.

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Summary

We compare the taxation, fees, investment options, and investor protection for two of the main investment account options[i]:


  • Taxable investment accounts are provided by banks, asset managers, stockbrokers, or investment platforms[ii]. You will pay tax on the investment income and capital gains as they arise from the investments you own in the account.


  • Offshore bonds function like accounts, as the value of your offshore bond is equal to the value of the investments and cash you hold inside it. However, offshore bonds are insurance contracts[iii] offered by offshore insurance companies, typically based in the Isle of Man or Ireland. You pay tax on your offshore bond gains when you encash part or all of it, rather than on the investments you hold inside the offshore bond.


Generally, the tax deferral and flexibility offered by an offshore bond may provide long-term tax advantages compared to a taxable investment account if you have high income or significant allocations to liquid assets that generate taxable income and gains.


When selecting your account provider(s), you should ensure they offer:

  • A suitable range of investments to support the efficient implementation of your financial planning strategy.
  • Account fees that represent good value to you.


An independent wealth adviser will work with you to build an efficient financial planning strategy that considers how to optimise your assets through the investment accounts available to you.

Taxation

Taxable investment account


Income from your investments is taxable in the year it arises. Capital gains from the sale 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 investment return.


The table below summarises the tax rates that apply to the different types of investment returns[v].

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

Offshore bond


Investments held within an offshore bond grow virtually tax-free. 


You pay tax on any ‘chargeable gains’ (increases in the account value) on the offshore bond when a ‘chargeable event’ occurs. Chargable events include encashment or partial encashment[iii] of the offshore bond.


The chargeable gain is classified as savings income and is taxed at the same rates as interest income.


The key tax features of an offshore bond for UK residents include:


Tax deferral - You do not pay tax until a chargeable event occurs. Deferring tax can enhance your net investment returns, as you benefit from compounded returns on gross income and gains that otherwise would have been taxed earlier. The longer the period of tax deferral, and the greater the rate of tax that would have been paid, the greater the benefit.


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


If you plan to emigrate, you may also be able to defer tax until you are no longer a UK resident, which could mean no UK tax is payable; you should consider the tax implications in your new country of residence.


5% cumulative withdrawals - You can withdraw up to 5% of your contributions each year without incuring an income tax liability, until you have withdrawn the full value of your contributions. 


This 5% allowance is cumulative; for example, if you contribute £2,000,000 and do not make any withdrawals in the first three years, you could withdraw up to £400,000 (20% of the contribution) in the fourth year. After 20 years, you can withdraw the full contribution.  


The 5% cumulative withdrawals enable you to defer tax for longer, by allowing you to access your original capital before you need to create a chargeable event.


Top-slicing relief – Broadly, top-slicing relief allows you to divide your chargeable gain by the age (in full years) of the offshore bond, to determine the tax rate you pay (though the full gain is taxed). This may result in lower tax rates on large gains. 


It is also possible to encash part of an offshore bond (realising part of the gain), meaning you can spread gains over multiple years. Depending on your other sources of taxable income, it may be possible to manage gains so that you only pay tax at the basic rate (20%) on gains.


Ability to assign – You can transfer assets, including those held in a taxable investment account, to your spouse and certain trusts without liability to capital gains tax. 


Offshore bonds also offer more flexibility, as you can also assign all or part to other family members, such as children or grandchildren, without a tax liability, and who may have lower marginal rates.

Comparison - Interest/income 


Income from assets such as cash and fixed income investments is taxed at the same rates as chargeable gains from an offshore bond. Therefore, deferring tax through an offshore bond may be efficient.


The following chart[vi] illustrates the change in the real value of £1,000,000 after taxes when 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 (solid green) and bottom (dotted orange) lines highlights the potential advantage of using an offshore bond if you are a higher or additional rate taxpayer who owns income-producing investments, but will become a basic rate taxpayer in the future.


In other words, 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


The tax rates on dividends and capital gains from investments in a taxable investment account are lower than the rates that apply to the chargeable gains on an offshore bond. 


Therefore, for assets that produce capital gains and/or dividends, such as company shares, you should weigh up the tax deferral available from an offshore bond against the lower rates of tax that apply in the taxable investment account.


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).

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

If you are likely to be a basic rate taxpayer in future, the offshore bond may be attractive for holding company shares. However, if you are likely to always be a higher or additional rate taxpayer, then, in this example, it takes nearly 30 years for the offshore bond to be a more tax-efficient account.

 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 accounts may be appropriate.

Fees

Account providers offer a wide range of terms for both taxable investment accounts and offshore bonds. Selecting an account that offers good value to you can have as much impact on your net returns as taxation.


Taxable investment account


Most investment platforms[ii] charge an annual percentage fee, typically in the range of 0.05% to 0.30%, with lower rates for larger investments.


Offshore bond


Offshore bonds generally have an annual fixed fee, perhaps in the range of £500 to £1,000 pa, and an initial percentage fee, in the region of 0.3% to 1.5%, again lower for larger investments. Some investment platforms offer offshore bonds and charge similar fees to their taxable investment accounts. 


Implications


Generally, larger accounts benefit from lower fees relative to their size. For smaller accounts, fixed fees can have a significant impact on returns, and many offshore bond fee models may not be appropriate. However, fixed fees are often favourable for larger accounts.


The pricing for both types of accounts, though structured differently, can be very competitive. High-quality advice and intermediation from an independent adviser will help ensure you achieve a competitive fee for an account that provides the features you need.

Investments

It is possible to access a wide range of investments through both taxable investment accounts and offshore bonds[vii]. 


You should ensure the taxable investment account or offshore bond offers a suitable range of investments to support the efficient implementation of your financial planning strategy.

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, to protect investors if the provider defaults.


Some investments, such as UK unit trusts and OEICs, are protected by the Financial Services Compensation Scheme (FSCS) up to a value of £85,000 per investment provider in the highly unlikely event that the investment provider becomes insolvent, causing a loss.


Offshore bond account


When you own an offshore bond, you own the contract of insurance, and the insurance company owns the investments held within the offshore bond. The insurance company is required to ring-fence policyholder assets from its own, to protect investors if the provider defaults.


If the assets were not available to pay your account balance when you want to withdraw funds, you may be protected by the investor protection scheme in the jurisdiction where the offshore bond is held. For example, the Isle of Man policyholder protection scheme should protect up to 90% of the policy's value. The UK FSCS does not apply to offshore bonds.

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Notes:


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


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


[iii] You can establish an offshore bond on a life-assured basis with a nominal amount of life cover (e.g., 1%), or on a capital redemption basis with a fixed term (usually 99 years). If set up on a life assured basis, the death of the last life assured is a chargeable event. If set up on a capital redemption basis, the end of the policy term is a chargeable event.


[iv] Individuals have annual allowances to earn small amounts of tax-free dividends (£500), savings income (£0 to £1,000, depending on your total income), and capital gains (£3,000). 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 gradually reduced for individuals with income over £100,000, and is not available to those who claim the 'foreign income and gains '(FIG) tax regime. Higher rates of capital gains tax apply to carried interests from private equity funds.


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


[vii] Offshore bond providers typically offer various investment funds, including unit trusts, exchange-traded funds (ETFs), open-ended investment companies (OEICs and their European equivalents ICVCs and SICAVs), and cash. The ability to own certain other assets, such as direct shares, may breach personal portfolio bond rules, which would not be tax-efficient.


General:


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


Before making investment decisions, 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 HMRC's practice at the time of writing. These may be subject to change in the future. Tax rates and reliefs may be altered.

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