The trick that middle-class families are now copying from the rich to beat soaring inheritance tax bills: As growing numbers are caught by the tax, here’s how it could work for YOU

As inheritance tax captures growing numbers of families in its net and bills rise, tax planning tools that have typically been prized by wealthy households are increasing in popularity.

Offshore bonds are one option that can be used to pass wealth through generations and to lower tax bills – if used correctly.

They have other benefits too – for example, they can be used to gift money to pay a grandchild’s school fees tax efficiently. Ian Dyall, head of estate management at wealth manager Evelyn Partners, says that there’s so much interest in offshore bonds at present that providers can barely cope with demand. 

‘The bonds can help older people who are worried about leaving their families with a tax bill but also want to be sure they have money left for retirement,’ he says.

Dyall himself acknowledges that it all sounds ‘too good to be true’ but says that if the bonds are set up correctly, they can save some families hundreds of thousands in tax.

However, they are complicated products that require expert help to set up and are typically only recommended to high earners and those who have already used up their pension and Isa allowances. In some cases, they could lead to higher tax bills.

What exactly are offshore bonds?

Offshore may sound like you’re hiding money from the taxman on a tropical island somewhere, but these bonds are legal when set up correctly.

They aren’t like traditional bonds that are issued by governments and companies. Instead, they are essentially investment accounts that are run by an insurance company in a low-tax part of the world, such as the Isle of Man, the Republic of Ireland or Guernsey.

They are structured as life insurance policies, into which you put a lump sum. You can then invest in the same assets as you might with a pension or an Isa, such as shares and bonds.

Will I be clobbered when it comes to tax?

These bonds can offer several key tax advantages.

Firstly, when you make investment gains on assets held in your offshore bond, you don’t have to pay tax on them immediately. Normally, when you sell investments in a general investment account you typically have to pay tax on the gains or income each year.

But with an offshore bond, the tax liability sits in the bond and you only have to pay it when you take the money out of it. Because you are not paying tax yearly, all of your money remains invested so you could end up with higher growth.

You can take 5 per cent of the original amount you invested out of the offshore bond every year without paying tax at the time, and if you don’t take it one year you can take an extra 5 per cent the next.

When tax is payable, you are charged income tax rather than capital gains tax. Income is charged at a higher tax rate than capital gains. However, you can time withdrawals so you make them in years when your income is lower, for example in retirement, to help keep your bill down.

How are they used to give away wealth?

The bonds can be divided into thousands of mini ‘segments’ that can be given away separately to different members of your family whenever you choose.

That means that you can hold on to the capital yourself and hand over segments when it is right for you.

When family members take money out of their segment, they will pay income tax on it. However, if they have low or no other income, their bill should be relatively low.

For example, grandparents sometimes use offshore bonds to help pay towards their grandchildren’s school and university fees. Grandparents gift a segment of the offshore bond every time there are fees to be paid. Each segment that you give may contain a tax bill that has been rolled up when investments have been sold over the years. However, the recipient can use their personal allowance to offset this bill, which could mean they pay little or no tax at all.

Everyone, even under-18s, can earn £12,570 of income a year without paying any income tax, so if the tax liability in the segment you’ve given them is less than this, the allowance will swallow up the liability and the money can be used in its entirety to pay a university or school bill, without any going on tax.

If you didn’t have an offshore bond and took the money from a pension instead, you would pay income tax on the withdrawals at your own marginal rate. This would be 20, 40 and 45 per cent respectively for basic, higher and additional rate taxpayers.

Plans like this need to be set up carefully, particularly where under-18s are concerned as you’ll need a special trust structure.

The rules are complex, but typically it’s only grandparents, not parents, who can give money for school fees in this manner without creating a tax liability of their own.

How do offshore bonds affect inheritance tax?

Offshore bonds do not automatically lower your inheritance tax bill. If you gift one – or segments of one – they could be liable for inheritance tax if you die within seven years because the normal inheritance tax rules apply.

The only way around this is to put the bond in trust, which moves it outside of your estate. Again, this needs careful planning and advice.

However, where they do come into their own is as a vehicle where you can hold wealth, take an income from and pass on segments as you choose.

This, in turn, should reduce the inheritance tax bill.

Inheritance tax is levied at 40 per cent on everything that someone leaves on death above £325,000 (with some extra allowances for your main property and giving money to a spouse or civil partner).

One way to bring this bill down is to give money away when you’re still alive. This is easier said than done, as most of us don’t know how long we will live or how much money we might need for care in future.

Harry Donoghue, wealth manager at Tideway and an offshore bond specialist, says that families are rushing to use offshore bonds because they deal with this conundrum.

‘They offer a very nice way of creating a tax-efficient income for one generation, and then as and when they’re ready, to hand that capital over to the next generation,’ he says.

Take, for example, Robert and Laura, a couple in their late 70s, who were concerned about inheritance tax but still needed access to their savings to live on.

They invested £300,000 in an offshore investment bond in a special legal structure known as a discounted gift trust.

Robert and Laura gifted the bond immediately to their son, and so if the couple live for seven years it should be completely free of inheritance tax.

However, the bond was set up in such a way that even though they have gifted it, Robert and Laura could still receive fixed withdrawals of £15,000 a year from it for the rest of their lives.

The taxman then accepts that the value of the gift is not £300,000 at all – and should not be taxed as such – because it will be diminished by the income taken.

To work out how much the income reduced the gift by requires a complex actuarial calculation taking into account how long the couple are expected to live for.

In Robert and Laura’s case, this was calculated as £75,000 so this sum was immediately outside of their estate for inheritance tax purposes, alongside any growth on the bond. If they were to die immediately, inheritance tax would only be payable on £225,000 of the £300,000 gift. The remaining £225,000 would fall out of their estate after seven years.

Sue Allen, from Chester Rose Financial Planning, who helped them set up the bond, says: ‘The result was that Robert and Laura were able to start reducing the value of their estate for inheritance tax purposes while still receiving the income they required for the rest of their lives.’

What you should be looking out for

It is easy to fall for a scam with such products, as they are complicated and fraudsters often target complex financial tools like this that people find hard to understand.

Make sure the firm you use is regulated by the Financial Conduct Authority and that you understand any exit penalties or other charges levied on the bond.

In most cases, the firms providing your investments in an offshore bond are large companies that are very unlikely to fail. However, it is worth noting that you aren’t covered for compensation by the Financial Services Compensation Scheme if yours does.

Look for a fee-based financial adviser with a good reputation so that you’re absolutely clear on whether this structure will work for your family. Tax breaks are all very well, but the product needs to be right for your family and you need to be comfortable with it before putting large amounts of money away for the long term in a bond like this.

Offshore bonds aren’t foolproof. Some families may actually end up paying more tax with a bond than without one.

For example, if an additional-rate taxpayer cashes in a bond segment, they could end up with a large bill.

James Scott-Hopkins, founder of wealth manager EXE, says that for some families it is simpler and safer to just use a conventional investment account in a trust and pay the tax liabilities as they arise.

‘This can provide greater transparency and help avoid the prospect of a larger deferred tax liability crystallising in the future,’ he adds.

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