What to know about tax on bonds and bond funds
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Okay, there’s no way to sugar this: I’m writing about tax on bonds, so I’ll keep it short, if not exactly sweet.
Bond taxation is confusing and life is fleeting and so – double-quick – here’s what you need to know to keep on the right side of the taxman:
- Bonds are not taxed the same as equities.
- Bond funds are not taxed the same as individual bonds.
- Offshore bond funds are not taxed the same as onshore ones. (In other words, the treatment may be different if your bond fund sits outside the UK.)
- Exchange-Traded Funds (ETFs) are not taxed the same as bond funds.
The following two tables sum up the income tax and capital gains tax treatments and differences between the main types of bond vehicle.
Further explanation lies beneath.
Tax on bonds: interest
| Bond fund (OEIC, Unit Trust) |
Bond ETF |
Individual gilt |
Individual bond |
|
| Tax on interest | Income tax rate (e.g. 20%) |
Income tax rate | Income tax rate | Income tax rate |
| Interest paid gross or net of tax | Net of 20% tax | Gross | Gross | Gross |
| ISA / SIPP shelter | Exempt (reclaim 20% tax withheld) |
Exempt | Exempt | Exempt |
Tax on bonds: capital gains
| Bond fund (OEIC, Unit Trust) |
Bond ETF |
Individual gilt |
Individual bond |
|
| Capital gains tax (CGT) | Payable | Payable | Exempt | Payable unless a qualifying corporate bond |
| Non-reporting fund (offshore) | CGT payable at income tax rate |
CGT payable at income tax rate |
n/a | n/a |
| ISA / SIPP shelter | Exempt | Exempt | Exempt | Exempt |
That’s the tax on bond and bond fund sitch in a nutshell.
Now let’s look at the details.
Where should you stash your bonds and bond funds?
If your fund is more than 60% invested in fixed interest and cash at any point during its accounting year then its distributions count as interest payments – not as dividends.
Distributions / excess reportable income will therefore be liable for income tax at your standard rate, rather than softie dividend tax rates.
If your interest is paid gross then you’ll need to pay income tax on it, unless it’s tucked inside your ISA / SIPP or you’re a non taxpayer.
Bond funds registered as OEICs or Unit Trusts pay interest with 20% tax already deducted.
- So a basic rate taxpayer has no more to pay. (Yay!)
- A higher rate taxpayer owes another 20%.
- A non-taxpayer is due 20% back.
If your bond fund is safely dunked inside an ISA or SIPP then you should automatically receive interest payments gross. However it’s worth a double-check email to your provider.
Non-reporting bond funds may pay interest gross. More on non-reporting funds below.
To hold an individual bond in your ISA or SIPP it must be listed on the stock exchange or issued by a listed company.
Individual gilts are immune from capital gains tax.
Gilt funds, however, pay tax on capital gains.
Following the great bond rout of 2022 – which scythed through gilt prices – the absence of CGT on individual gilt gains could make holding low-coupon gilts with high redemption yields the most tax-efficient option for you. Do your sums carefully.
Offshore bond funds
If an offshore fund / ETF does not have UK reporting status then capital gains are payable at income tax rates.
That’s bad news because capital gains tax rates are much friendlier than income tax. The £6,000 tax-free capital gains allowance – falling to £3,000 from 6 April 2024 – would count for nought in this instance. And higher-rate taxpayers would pay (income) tax on their capital gains at 40% instead of 20% in CGT.
Make sure your offshore bond tracker says it’s a reporting fund on its factsheet. HMRC also publish a list of reporting funds.
Offshore bond funds / ETFs are subject to withholding tax just like equity funds.
If your bond fund is domiciled in the UK then reporting status and withholding tax isn’t an issue.
Index-linked Gilt ETF vs Index-linked Gilt Fund taxation
Some UK-based index-linked gilt funds are exempt from income tax on the inflationary component of interest payments.
In other words, if inflation shot up 5% in a year and the gilt paid 1% interest on top of that, then you’d only pay income tax on the 1% and not the other 5%.
However, offshore index-linked gilt ETFs will generally impose income tax on the whole interest payment (including the inflation-based element) because they do not enjoy the same exemption as an onshore fund.
So if you’re stocking up with an index-linked gilt fund then look for a tracker fund that’s based in the UK. (Email the provider to make sure they’re packing a tax exemption on inflation-linked interest.)
Take it steady,
The Accumulator
Note: This article on tax on bonds is an updated version of our 2015 original. Comments below may refer to old information, so double-check anything before acting. We’ve left old comments intact as there’s some good tidbits as usual.
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