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Are bonds tax free? Your gilt questions answered

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This content is for information purposes only and should not be taken as financial advice. Every effort has been made to ensure the information is correct and up-to-date at the time of writing. For personalised and regulated advice regarding your situation, please consult an independent financial adviser here at Castlegate in Grantham, Lincolnshire or other local offices.

Bonds can be a powerful asset class to include in an investor’s portfolio. Yet how do they work, exactly? How do they relate to taxes, and what can you do to “shield” your returns (e.g. capital gains) as much as possible?

Below, our financial advisers in Lincoln offer this short guide answering commonly asked questions about bonds. We hope these insights are helpful to you.

To discuss your own family financial plan with us, please get in touch to arrange a no-obligation financial consultation at our expense:

01476 855 585

What are Bonds?

Let us start with a definition of a bond. In short, a bond is a bit like a bank loan. However, you (the investor) are the one lending the money – e.g. to a government or company.

The latter promises to eventually repay you, with interest (the “coupon”), by a specified date in the future (the “maturity date”). Lending to a company falls into the “corporate bond” category. A bond issued by the UK government to investors is called a “gilt”.

For instance, suppose you buy a £100 gilt with a 2-year maturity date and a 2% coupon. At the end of 24 months, the UK government should give your £100 back to you, together with £4 interest (from the 2% coupon each year, usually paid in 6-monthly intervals).

Introduction to Bonds and Taxation

An investor can earn returns from bonds in two main ways. One way is to buy a bond, wait until the principal is returned on the maturity date and enjoy the coupon received along the way.

Here, the interest income (from coupon payments) can fall under an investor’s income tax liability. This may occur if an investor has fully used up their personal savings allowance for the tax year (the tax-free amount they can earn from interest outside of an ISA).

For example, in 2024-25, a Basic Rate taxpayer can earn up to £1,000 from interest each tax year—including bond interest income—without paying tax. Above that threshold, a 20% income tax rate would apply to the taxable income.

The second way to earn a return from bonds is to sell your existing bonds to other investors for a profit (before the maturity dates), generating capital gains. Here, capital gains tax may apply to the gains you generate from these “asset disposals”.

Navigating Bonds and Capital Gains Tax

One powerful way for investors to mitigate capital gains tax on their bonds is to hold them inside their ISA(s). In 2024-245, an investor can contribute up to £20,000 to ISAs each tax year. Inside, the investments can generate interest, capital gains and dividends without the need to pay tax.

If you want to release a capital gain outside of an ISA, consider using the UK’s tax rules to your advantage. For instance, one approach is for an investor to “spread out” asset disposals across multiple tax years, utilising their tax-free allowance for capital gains (the “Annual Exempt Amount”) each year.

In 2024-25, capital gains tax does not apply to the first £3,000 of chargeable gains for an individual within a single tax year. As such, generating £6,000 in one tax year might result in a capital gains tax liability. However, generating £3,000 each year over two years might “shield” your returns.

Protecting Bonds From Income Tax

What about bonds and taxable income? How can you mitigate your liability in this respect? One idea is to be mindful of your personal savings allowance.

In particular, are you at risk of breaching your tax-free limit for interest income in the present tax year? If so, perhaps it is time to reorganise some of your finances.

For example, an investor could use the “bed and ISA” approach to move certain bond assets from a general investment account to their ISAs (where the interest from coupons will be tax-free). Another option could be to move certain cash savings into a Cash ISA or Premium Bonds, allowing for more of your bond interest income to fall within the scope of your personal savings allowance.

Also, be mindful of your wider taxable income. A Higher Rate taxpayer only gets a £500 personal savings allowance, whilst a Basic Rate taxpayer gets a £1,000 personal savings allowance. As such, if your earnings could enter the Higher Rate for the tax year (e.g. if you are near the tax band), you could inadvertently restrict your tax-free interest income.

To address this, consider speaking with a financial adviser about different options (e.g. using salary sacrifice to avoid needlessly entering a higher band on taxable income).

Final Thoughts

There are other ways to limit income tax and capital gains tax on bonds.

For example, purchasing bonds directly from the issuer rather than indirectly via a fund may be free from capital gains tax if HMRC regards them as “qualifying corporate bonds.” UK gilts are also exempt from capital gains tax if held directly by an investor.

However, seek professional advice to explore these options in more detail as they involve wider financial planning considerations (e.g. ensuring diversification).

Mitigating needless tax on your investments is important, but it is not the end goal. Remember that your bonds and other assets should be a means to an end, such as achieving a comfortable retirement.

If you are interested in discussing your own financial plan or investment strategy with us, please get in touch to arrange a no-commitment financial consultation at our expense:

01476 855 585