INVESTMENT bonds are a popular form of investment for many people.

They can be used to provide for inheritance tax liabilities or to provide tax free income. They can also produce some considerable tax shocks for the unwary.

In a recently reported case, the taxpayer faced a staggering income tax charge of around £370,000 on a bond gain of around £45,000.

The tax tribunal was told that he now faces bankruptcy simply because he ticked the wrong box on a form.

The bond – as is generally the case - was made up of a cluster of life insurance policies.

There are various ways to take money from such a bond. Normally up to 5% of the original investment can be taken tax-free with any excess over that amount being treated as having had basic rate tax already paid.

Things can however become much more complicated where a partial withdrawal is made as the taxpayer in this case found to his (considerable) cost.

There is not space to go into all of the details here, but one of the reasons investment bonds are generally written as a cluster of policies is to give flexibility.

If the taxpayer in the case I have mentioned had fully encashed some of the policies rather than making a partial withdrawal from each of them the income tax result would have been very different.

Bonds can be a very effective way of providing for inheritance tax, but they can also create inheritance tax disasters.

To be effective for inheritance tax a bond must be written in trust for specified beneficiaries (specifically excluding the person who has made the investment).

If the bond is not written in trust it will fall into the estate of the investor, increasing the inheritance tax bill on the investor’s death rather than helping to provide cash to pay the tax.

By writing the bond in trust, its value will (as long as the investor survives the creation of the trust by seven years) fall outside the investor’s estate.

Irrespective of how long the investor lives, any increase in value from the date of the trust will escape inheritance tax altogether.

Bond taxation is a very complex area and specific advice should always be taken both at the outset and before making any withdrawals. Ticking the wrong box on a form can have dramatic and irreversible consequences.

*Paul Aplin OBE is a tax partner with A C Mole & Sons and chairman of the Technical Committee of the Institute of Chartered Accountants in England & Wales Tax Faculty; you can follow him on Twitter @PaulAplinOnTax. He and fellow tax partners Amanda Gunter and Paul Kingdom can be contacted on 01823-624450.