Why should savers use a savings bond

With the Bank of England's base rate so low at 0.5% most savings accounts with banks and building societies offer derisory rates of interest.

At the end of last year the average branch based instant access account, with a bank or building society, paid just 0.17%.

And a notice account paid barely more at just 0.33%.

However, if you look at the best-buy tables in newspapers or on comparison websites. you will notice that some of the best rates are with fixed-rate bonds.

If you are happy to tuck your money away for five years you can get more than 5% interest.

How do they work?

The growth of the investment is limited to the interest paid on the account.

Savings bonds differ from normal deposit accounts in that they have a fixed set period, usually one, two, three or five years, and the rate of interest is set at the start of the term.

The interest earned each year is rolled up into the account instead of being paid out.

Once the money has been placed on deposit savers are usually restricted on the number of times they can withdraw the money during the lifetime of the bond.

Additionally, any early encashment is often charged with a loss of interest.

Banks and building societies offer these investments with more attractive rates of interest because they want access to secure long term deposits.

So the longer the timescale the better the rate being offered.

Currently, the best five year savings bond will offer 5.1% (AA or Saga) per annum compared to the best instant access accounts offering 2.80% (Halifax).

Should you consider them?

Investors need to consider several things when deciding whether they should buy a bond and how long it should

When will you need the money?

Do not just go for the better rate but ask yourself when you might need the money.

The cost of borrowing extra cash will be greater than the return you are getting on the money in your bond, even with a good rate.

What are your expectations for interest rates? This is more difficult to call.

No one knows where interest rates will be in five years time.

But considering how low the Bank of England rate is now, savers can be more comfortable with getting good rates for just one or two years, and this gives the flexibility to reinvest again in a few years time.

What benefits do you give up for the better interest rate?

For the better return, savers do give something up - the access to their savings for a set period and access now to the interest earned.

So for savers who need an income now these products may not be suitable.

There is also the possibility of losing the chance to use the money more profitably, perhaps by investing in other assets such as equities, or paying off a mortgage.

Investment bonds

Investment bonds are fundamentally different and involve investment not saving.

The policies are typically sold by life assurance companies which allow you to invest in a variety of funds (either investment trusts or unit trusts) managed by professional investment managers.

They are usually designed for long term capital growth but can also be used to generate income.

Investment bonds can invest in a wider range of assets than savings bonds, such as UK and overseas equities, commercial property and fixed interest securities, as well as cash- like investments.

Investors are able to decide how much of their money goes into which funds and are able to change the mixture of their investments several times a year.

With-profits

In the 1990s a particular type of investment bond became more popular; with-profits bonds (WPBs).

The aim of these was to smooth out the gains and losses of the investment over the life time of the bond.

The life insurance companies had control of the investment decisions and determined what the bonuses were.

The "tech bubble" collapse in 2000 saw a lot of investors in these products lose money.

Any early encashment was met with tough exit penalties called market value adjusters (MVAs).

These were introduced to protect investors who remained in the bond from being adversely affected.

The losses made, and the introduction of MVAs, have resulted in WPBs becoming less popular.

Taxation

For tax purposes, investment bonds are treated as life assurance policies and therefore are subject to tax on the income and gain.

However, it is the life company that pays the tax at their rate of tax, which may be lower than basic rate income tax an individual would be liable to pay.

Investors are not subject to capital gains tax, or basic rate tax on gains or income.

Higher rate tax payers may be liable for any additional income tax above the basic rate (currently 20%) but only when they cash in the investment, or make partial withdrawals of over 5%.

There are special rules on insurance bonds where investors can take, or top slice, 5% of the value of the fund from the capital and take it without paying tax.

This top slicing is a deferral of income tax and the investor will be liable for tax on the whole when the investment is cashed in, but only at the time of encashment.

Points to ponder

Investment bonds may be recommended in a number of situations.

If you are a higher rate taxpayer looking for extra income, an investment bond may be suitable because the 5% annual withdrawal facility would mean there is no immediate tax liability.

The 5% withdrawal facility would be useful if you are retired and want a supplementary income.

But you would be in danger of falling into the age allowance "trap".

This is where the higher personal tax allowance you receive when you are 65-74 (£9,490 for 2009-10) is reduced if your annual income exceeds a certain level (£22,900 for 2009-10).

If you are an active investor with a large investment portfolio and you have already mopped up your annual capital gains tax allowance (£10,100 in 2009-10), you can use an investment bond to manage your investments, and you will not be liable for capital gains tax when you make switches between investments.

However, in general, investors should use their personal ISA allowance (£7,200 for those under 50 and £10,200 for those who are 50 or older by 5 April 2010) first before considering investment bonds.

The opinions expressed are those of the author and are not held by the BBC unless specifically stated. The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.

be invested for.

A savings bond is a bank account where your money is held on deposit and on which you earn interest.