Growth bonds and income bonds

Both growth and income bonds from insurance compa.lies have been very popular, in view of the high net yields which can be offered to investors. There is little doubt that an appreciable amount of the investment in these bonds has been made with funds withdrawn from building societies.

Although most bond investments do, not have the same flexibility as a building society investment (in that withdrawal cannot be made virtually on demand without penalty), the tax advantages are an important selling point. The purchase price paid for both types of bond is invested in the general annuity fund of an insurance company, which, in practice, is virtually a gross fund.

The tax position for the insurance company is that, so long as the investment income does not exceed the gross figure paid out in the form of annuities, the investment income is free from tax. Naturally, the insurance companies are careful to control their inflow of business so as to maintain the right balance.

It is for this reason that issues of growth bonds (which compound in value) generally are restricted. When these bonds are sold, other business has to be used to maintain the right balance in the fund. Income bonds, on the other hand, are more or less selfbalancing from the tax point of view, and thus can be put on continuous offer by insurance companies.

From a bond holder's point of view, provided he is paying no more than the basic rate of tax when he decides to take the cash from a growth bond at the end of the predetermined term (or surrenders it for cash before that date), there will be no income tax or capital gains tax to pay. The cash can be taken from the insurance company, without any tax deduction.

On the other hand, there will be a tax liability for anyone paying higher rate tax at the time, or who is brought into the higher tax bracket as a result of realising the bond. Ideally, therefore, a growth bond should continue in force until it is estimated that one's income will be relatively low (e.g. during retirement) so as to keep the tax liability as low as possible.

To calculate the tax liability, the dif ference is taken between the original purchase price and the cash received at the end of the term (or at earlier • surrender). This figure represents the ' gain ' which has been made. To arrive at the rate of tax to be applied, the amount of the gain is divided by the number of full years for which the contract has been in force. The resulting proportion of the gain is added to the bond holder's total income for the year. In this way, the appropriate higher rate tax is established. The whole of the gain is then chargeable at that rate, less basic rate tax.

If, at the end of the term, an income for life is. taken, instead of cash, part of each payment will be free of tax, being looked upon as a repayment of capital.

Unfortunately, however, the capital element of this annuity is calculated on the original purchase price, and not the value of the cash option at the end of the term. Even, therefore, if an income for life is required, it is likely to be best to take the cash. This can then be used to buy an immediate annuity from an insurance company. A higher proportion of the benefits will be free from tax.

Most of the income bonds on the market consist of two different contracts. In the first place, part of the original capital sum is used to buy a growth bond. This is so that, at the end of the term, the whole of the original purchase price can be returned.

The other part of the original capital simply buys a temporary annuity. This contract pays out the income over the period, but there is no capital return from it. As a substantial part of the income is effectively repayment of capital, only a comparatively small proportion of the income is taxable. It is for this reason that such attractive grossed up yields are available from income bonds.

From the tax aspect, one point to watch about income bonds is that there is a growth bond element in them. This means that anyone paying tax at the higher rates at the end of the term of an income bond will have some tax liability. The practical effect, therefore, will be that the net return will be less than the original purchase price paid for the bond.

Insurance companies have tackled this problem in various ways. For instance, one bond was introduced so as to return 125 per cent of the original purchase price at the end of the day. The aim was that, after tax, the capital would still represent more than the original purchase price.

Some companies are offering a completely different type of income bond. It does not contain a growth bond element, but there is not an absolute guarantee that the full amount of the purchase price will be returned. The actual amount will depend on profits earned. In practice, however, the taxfree capital at the end of the day could represent more than the original purchase price.

This type of income bond is arranged for a ten-year period. Most of the original investment buys a temporary annuity, so as to pay out a pre!. determined income each year. A small part of the original investment pays the first premium towards a profit sharing qualifying endowment life assurance policy. Further premiums are met from the income from the annuity, with the balance of this income being kept by the bond holder as his yield on the investment.

At the end of the ten-year period,

the maturity value .ot the life policy should repay the whole of the original investment — with no tax to pay. Nevertheless, the actual amount which will be repaid will depend on bonuses declared during the ten-year period while the policy has been in force. Although there is no guarantee about future bonuses, most of the old established traditional offices are quietly confident about their ability to maintain their current rates of bonus.

Since part of the income from the temporary annuity is used to pay premiums on the life policy, the amount retained by the bond holder (and thus the yield on his original investment) will depend to some extent on the amount of tax relief which can be claimed on the premiums paid towards the life policy. Normally, this relief represents 15 per cent of the premiums, but there are limits to the relief. In practice, therefore, dependent on individual circumstances, it may not be possible to claim relief at this rate on the full amount of the premium paid.