Is it time to break free from your bonds? Recent changes in tax legislation are causing many investors to ask whether they should be selling their investment bonds and reinvesting the proceeds elsewhere. Read on to find out the answer with our guide to investment bonds.

Within investment bonds any growth in the value of the underlying investment is taxed on an ongoing basis within the fund at around 20%. When you sell, your gains are liable to income tax and so you might pay up to 20% more tax when you cash in your bond if you are a higher rate tax payer, or the gain is deemed to make you one (the means of calculating this is known as top slicing). Whereas with a comparable unit trust investment you only pay capital gains tax at the new, flat rate of 18% regardless of the rate of income tax you pay.

This means unit trusts are now often better from a tax perspective than investment bonds and, of course, less tax means a better return for you. Effectively the same investment in a unit trust would now outperform a bond. However you need to consider why you invested in it. For instance, if it was for inheritance tax planning it maybe that the reasons are still entirely valid. The comments below apply to those who bought their bonds for pure investment purposes.

With profit bonds were one of the most common types of investment bond. We have been suggesting to our clients for the past five years that they should not invest any more money in with profits bonds and, where the exit fees are reasonable, withdraw the proceeds and reinvest elsewhere. Certainly if your with profit bond is not actually in profit there appears to be absolutely no reason why you should keep it, even if you are a higher rate taxpayer.

The decision is a little more difficult if your with profit bond is in profit but only if you pay higher rate tax, or if encashing your bond will take you into the higher tax bracket. In these cases surrendering a bond would create a tax liability although even then there is an argument for actually encashing the investment bond, it will depend on your circumstances and views.

Quite simply, assuming the bond continues to rise in value, someone who will always be a higher rate taxpayer will have a tax liability whenever they encash it. Therefore, it could make sense to sell the bond now, pay the tax (rather than pay more tax on a potentially larger profit in the future) and then reinvest the proceeds in more tax efficient investments.

Reducing your tax liability and switching to another form of investment which offers better investment returns could significantly increase your net return in the future.

Is there anything else I should consider?

Some bonds have exit penalties so before you encash your bond check whether you will be liable to any charges. If you decide to encash, the final consideration is where to reinvest the proceeds.

If you would like to assess your options go to our new investment bond calculator (5) which will help you see how much tax may be payable if you decide to encash your bonds.

Comment provided by Hargreaves Lansdown, an independent broker aiming to provide the best information, best service and best discounts on ISAs, SIPPs, funds and share dealing .