When bonds can create a taxing problem

With profits bonds have won a reputation as a low-risk invest- ment with potential tax advantages, but their squeaky clean image has been tarnished lately. Falling returns, shortfalls on endowment mortgages, and the plight of Equitable Life with profits fund members have all taken their toll.

With profits bonds have won a reputation as a low-risk invest- ment with potential tax advantages, but their squeaky clean image has been tarnished lately. Falling returns, shortfalls on endowment mortgages, and the plight of Equitable Life with profits fund members have all taken their toll.

But with profits bonds remain hugely popular, estimates suggest there are a massive 43 million policies in the UK. Are the tax benefits still worth having - or should you find somewhere else to put your money?

With profits bonds are used in insurance bonds, pension savings plans and endowment policies. They have traditionally been seen as a halfway house between safe but dull bank and building society savings accounts, and the choppier but potentially more rewarding waters of the stock market.

They invest in a mixture of shares, corporate and government bonds, property and cash. Each year they pay a bonus, the prime attraction for cautious investors as it cannot be eroded in future years even if stock market returns slump thereafter. If there is a surplus at maturity, your funds could be further boosted by a terminal bonus. But investment returns have fallen over the last 18 months and recent news is no more promising, with Friends Provident and Scottish Provident announcing disappointing bonuses. Others, including Axa, Sun Life, Clerical Medical, Norwich Union, Legal & General, Scottish Widows and Standard Life, are likely to leave investors disappointed.

Mark Dampier, head of research at financial advisers Hargreaves Lansdown, says with profits bonds still sell by the "bucketload". "We are all waiting for the next set of bonus rates to see how badly they have fared, although you should remember that over the last five or 10 years, bonds by the Prudential, Scottish Widows and others have returned around 10 per cent a year," he says.

Bonds have traditionally been used by older, cautious investors to protect their accumulated investment gains as they approach retirement, when the capital can be used to draw a regular, tax-efficient income. With profits bonds have basic rate income tax deducted at source, and basic rate taxpayers pay no further tax. Returns are not liable for capital gains tax. Higher rate taxpayers may have to pay the difference between the 22 per cent basic and 40 per cent higher tax rates (18 per cent), but this can often be avoided with some clever manoeuvring.

Under Inland Revenue rules, higher-rate taxpayers can withdraw up to 5 per cent of their original investment each year for up to 20 years, without being hit by an immediate income tax bill on that money. "The Inland Revenue considers this 5 per cent withdrawal to be a return of your own capital. If you decide not to take out 5 per cent one year, you could take out 10 per cent next year, or 15 per cent the following year and so on. These returns don't even have to go on your tax return form," Dampier says. Brian Dennehy, financial adviser with Dennehy Weller & Co, says by the time they finally encash the bond, many higher-rate taxpayers will have seen their income fall in retirement and will only be paying basic rate tax. "If they are a basic-rate taxpayer by then, they may have little or no extra tax to pay. This is a neat way to defer your higher rate tax liability, or even avoid it."

Higher-rate taxpayers who withdraw more than 5 per cent a year must pay a further 18 per cent tax on that additional money. He also warns that the more withdrawals you make, the less capital you will have in the bond to grow and attract bonuses.

But while higher-rate taxpayers fare well under with profits bonds, others do not. "These bonds penalise non-taxpayers, because basic rate tax is deducted from the fund at source and investors cannot claim this back. They should look elsewhere. Basic-rate taxpayers will find the tax position is largely neutral. They will have no further tax to pay on withdrawals, because they have already paid that tax within the fund," he says.

Dennehy warns with profits bonds are not cheap. "They have been oversold by some financial advisers because they pay commission of between 5-6 per cent. By comparison, unit trust investment funds pay just 3 per cent commission, and profit margins are lower."

Dennehy Weller operates a website that grades the best value with profits bonds (www.bonds-topten.com). Current favourites are bonds offered by insurers Liverpool Victoria, Clerical Medical, Britannic and Royal & SunAlliance, although he stresses future performance is not guaranteed. John Hainsworth, independent financial adviser with Rickman Tooze, says with profits bonds should be used as one weapon in a battery of tax-efficient investments.

"Somebody looking to invest a large lump sum in a tax-efficient manner should first use their annual £7,000 ISA allowance. Then they could invest in unit trusts and investment trusts, avoiding a tax bill by drawing money within their annual capital gains tax allowance, currently £7,200. Finally, they could invest the remainder of their money in with profits bonds to maximise the tax breaks on offer." But he warns that basic rate taxpayers with larger sums invested in with profits bonds could inadvertently land an additional tax bill if their gains push them into the higher rate tax bracket for that financial year. When investors encash their bond, the Inland Revenue calculates the average annual profit, then adds this to their taxable income for that year.

"If you have a large profit when you surrender your bond, you could lose heavily if that pushes you into the higher-rate tax bracket. It is better to strip out money from the bond regularly, to spend on things you enjoy and reduce your tax liabilities," Hainsworth says.

Financial adviser Andrew Merricks, partner of Simpsons of Brighton, warns against putting tax considerations above investment potential when deciding whether to go for with profits bonds. He believes bonds have been oversold and have underperformed.

"With profits bonds are inflexible, often with exit penalties in the first five or six years, so you will lose out if you want to switch investment. Returns from a low-risk equity fund will generally be far better."

* Contacts: Hargreaves Lansdown 0117 900 9000; Brian Dennehy 020-8467 1666 or www.bonds-topten.com; Rickman Tooze 020-7405 4220; Simpsons 01273 270222

* Contacts: Hargreaves Lansdown 0117 900 9000; Brian Dennehy