Offshore bonds: the new pensions

Wealthy are looking for alternatives as reliefs vanish.

From next April, those earning more than £130,000 a year will gradually lose their higher-rate tax relief under changes designed by Labour and, so far, maintained by the coalition.

Offshore bonds provide significant tax savings for investors because you can withdraw up to 5% of your capital while deferring higher-rate tax.

Danny Cox of Hargreaves Lansdown, the adviser said: “The argument for an offshore bond has become a lot more compelling for high earners facing the loss of higher-rate relief on pension contributions. Clients are reluctant to tie up money in pensions in return for comparatively little tax relief.”

The schemes are also becoming a popular way to meet the cost of private school fees. According to SG Hambros, the wealth manager, parents facing the 50p top tax rate — those earning more than £150,000 a year — could save as much as £51,000 using offshore bonds to save for school fees. Those in the 40p higher-rate tax bracket could save £42,000, SG Hambros said.

How do offshore bonds work?

Offshore bonds are an insurance “wrapper” round a portfolio of investments, which receive tax advantages by allowing you to defer the tax on the growth of the investments.

Capital growth in an onshore bond is taxed at 20%, whereas offshore bond capital grows tax free.

While basic-rate taxpayers have no more tax to pay when they cash in an onshore investment bond, higher-rate taxpayers must pay a further 20% and top-rate taxpayers must pay 30%.

With offshore bonds, there is no tax to pay until you encash the bond, when higher-rate taxpayers will pay the entire 40% and top-rate payers will be liable for 50%.

If you invested £100,000 in an onshore bond, you would have a lump sum of £155,000 after 10 years with growth of 6% a year, according to Barclays Wealth. If you invested the same in an offshore bond, a higher-rate taxpayer would have £196,000 at the end of the term — an extra £41,000 as gains would have rolled up gross. Also, bonds allow withdrawals of up to 5% a year for up to 20 years with no immediate tax to pay. In effect, you are “rolling up” the tax, which could mean big savings for those who expect to move to a lower tax rate later in life.

Assuming a higher-rate taxpayer cashed in the £196,000 bond while still in Britain, they would pay £48,000 at 50%. However, if they encashed the bond in Italy they would pay just 12.5% or £12,000, assuming they had been resident for a year. In Spain, they would pay 18% or £17,000, according to figures from Barclays Wealth.

What about the fees?

Charges are high, typically 0.3% to 1% upfront plus £400 to 0.25% a year, depending on how much you invest. Adviser commission on top means the bonds are generally best for investments greater than £100,000 held for more than five years.

How do they compare with pensions?

If you invested £80,000 in the offshore bond, it would have a value of £231,086 in 20 years assuming a 5.5% return and charges of 1% a year.

After basic-rate tax it would be worth £200,869, or £170,652 for a higher-rate taxpayer. You could withdraw an income of £16,242, or £13,180, by taking advantage of the 5% rule. This income would last 20 years.

By comparison, a top-rate taxpayer who made an £80,000 pension investment grossed up to £100,000 (if eligible for basic-rate tax relief only), would have a £320,714 retirement pot. After taking 25% tax-free cash at £80,178, there would be an annuity of £9,381 for a higher-rate taxpayer or £12,508 for a basic-rate taxpayer.

Cox said: “If the investor were to die at the age of 77 after taking an annuity each year for 12 years, the tax savings would be identical when using an offshore bond or a pension. However, the plus point for the offshore bond is that you will have been able to make the 5% withdrawal at any time.

“We are increasingly recommending these schemes for retirement saving for higher-rate taxpayers who use their Isa and capital gains allowance, and no longer benefit from high-rate tax relief.”