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Profits of Bonds

Are you currently looking to receive an additional income from your capital? Well, there is a product that lets you take an income without any immediate worry about tax, which lets you control how much income you receive, and which grows steadily but is less likely to immediatly fall in value if the stock market plunges. Where can you find such an investment? Look no further than a with-profit bond.

No more peaks and troughs
With-profit bonds invest in insurance company with-profit funds. Typically, the minimum investment accepted is £5,000. The tax status of qualifying bonds effectively means that no capital gains tax is payable on the proceeds. If you are a basic-rate taxpayer, there is no further tax to pay unless any gains that you make take you into the higher rate tax bracket.

With-profit funds generally invest in a mixed portfolio. Gains from the fund are shared out to investors as annual bonuses. Each year, a life company will declare the bonus to be paid out to its with-profit fund holders and, once these bonuses have been declared, the life company cannot take them back. There is no guarantee that future annual bonuses will be paid.

As well as annual bonuses, you may also receive elements of what is called the 'terminal bonus'. With-profit bonds don't have a fixed term, so elements of the terminal bonus are either paid throughout the term or when the bond is cashed in - the approach varies. However, this terminal bonus is not guaranteed and its payment and size depends on the performance of the bond's underlying funds during its term.

A flexible income
One of the attractions of with-profit bonds is that they allow you to decide how much income to take. Most modern with-profit bonds offer flexibility of income payments. Each year, you can withdraw up to 5% of your original lump sum with no immediate liability to tax, and you can keep doing this for 20 years - or until you have effectively withdrawn all your original capital. Usually, you have the option to have your income paid automatically into your bank account, and you can take this payment either monthly or quarterly.

The great advantage of with-profit bonds is that, if you withdraw less than 5% in a year, you can make up for it later.

Taxing matters
As with all single-premium life insurance investments, the fund itself is subject to tax. With-profit bonds are considered 'tax paid'. All proceeds are deemed to have basic-rate tax already deducted, so lower and basic-rate taxpayers have no further tax liability.

A tax liability falls on you only if you are a higher-rate taxpayer at the point you take money out. When you finally encash your bond or exceed the 5% allowances, the profit made from your bond is averaged over the life of the bond and added to the rest of your annual income for that year. This means that if your total income falls into the higher-rate tax bracket, tax might be payable. This process is known as 'top-slicing' and is quite a complicated calculation. We can explain this in more detail when appropriate to your own situation.

The main purpose for deferring the tax if you are a higher-rate taxpayer is so that, when you encash the bond, you do this when you are a basic-rate taxpayer in order to redue the tax paid.

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Are bonds a good choice for me?

Typically, younger investors buy more stock and fewer bonds than older investors. Bonds are a more conservative asset class than equities, and offer less risk as well as less potential for growth.

Five reasons to buy bonds

1. They can help provide a steady flow of income from interest.
2. You usually get your money back if you hold a bond until it matures.
3. They can provide you with opportunities to make money by selling them at a higher price than you paid for them. Of course, you can lose money on your bond investments too, if you sell before they mature.
4. You can lower your risk when you invest by having some of your money invested in bonds.
5. Bonds may do well when other types of investments do not.

There are many different types of bonds to choose from, including bonds from different governments and industries, with different maturity dates and different interest rates. Investors often buy bonds that mature and pay interest on different dates. This is known as bond laddering. Laddering can help you reduce the impact of changing interest rates and make investing in bonds work better for you.

Three reasons to ladder your bonds

1. You get access to cash at different times, cash that you can either use or reinvest.
2. If interest rates rise over time, you will be able to buy some bonds later that pay higher rates.
3. If interest rates fall, laddering helps reduce the risk that all your bonds will mature at a time when interest rates are low.

Tip: Some retirees ladder bonds as an alternative to buying an annuity. They set up their bond purchases to supply a regular flow of income. Of course, they’ll spend more time tracking and keeping records of their investments than they would with an annuity, but they also retain more control over their money. For example, they could sell a bond early if they had a cash emergency. You can't get extra money for emergencies from an annuity.
Remember: Like any investment, bonds have risks

Laddering can help you reduce the effect of changing interest rates and make investing in bonds work better for you. You may want to work with an adviser to choose the right bonds for your investment portfolio.

Basic Terms of Bonds

One of the key investment features of any bond is its maturity. A bond’s maturity tells you when you should expect to get your principal back and how long you can expect to receive interest payments. (However, some corporates have “call,” or redemption, features that can affect the date when your principal is returned. See Understanding ‘Call’ and Refunding Risk.)

Corporate bonds, in general, are divided into three groups:

* Short-term notes
Maturities of up to 5 years
* Medium-term notes/bonds
Maturities of 5-12 years
* Long-term bonds
Maturities greater than 12 years

Structure

Another important fact to know about a bond before you buy is its structure. With traditional debt securities, the investor lends the issuer a specified amount of money for a specified time. In exchange, the investor receives fixed payments of interest on a regular schedule for the life of the bonds, with the full principal returned at maturity. In recent years, however, the standard, fixed interest rate has been joined by other varieties. The three types of rates you are most likely to be offered are these:

Fixed-rate Most bonds are still the traditional fixed-rate securities described above.

Floating-rate These are bonds that have variable interest rates that are adjusted periodically according to an index tied to short-term Treasury bills or money markets. While such bonds offer protection against increases in interest rates, their yields are typically lower than those of fixed-rate securities with the same maturity. (See Understanding Interest-Rate Risk.)

Zero-coupon These are bonds that have no periodic interest payments. Instead, they are sold at a deep discount to face value and redeemed for the full face value at maturity. (One point to keep in mind: Even though you receive no cash interest payments, you must pay income tax on the interest accrued each year on most zero-coupon bonds. For this reason, zeros may be most suitable for IRAs and other tax-sheltered retirement accounts. Other tax aspects of zeros are discussed under

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