Onshore life insurance policies can be a tax efficient vehicle for holding your investments. You can roll up income and capital gains free of tax until you cash in the policy. While you do not pay tax, the life company does pay tax of around 20% on the underlying investment. The tax is equivalent to the basic rate of tax and cannot be reclaimed. This basic rate of tax does vary according to the asset classes held within the portfolio, however.

Once you cash in the policy, the effective rate of CGT is around 36% for top rate taxpayers rather than 40% on investments outside an insurance policy. This is because the life office pays tax at a rate of 20%. You then pay 20% on the remaining assets. This means the remaining 80% of capital is subject to the 20% rate of tax. This leaves 64% of the original capital and provides a total tax bill of 36%.

While this is more attractive than the 40% rate outside an insurance policy, it is important to remember that you cannot benefit from your CGT allowance within an insurance bond. In the 2006-07 tax year, you can make gains of £8,800 before they are subject to CGT.  For a married couple, this is obviously £17,600. If you are actively trading your portfolio, it may be advisable to use an insurance bond. But if you are not actively trading, it may be preferable to invest in funds outside an insurance bond to take advantage of your CGT allowance to reduce your tax bill.

If you switch investments between funds within an investment bond, this is free of CGT. It is possible to assign the policy to people who are not higher rate tax payers so any investment gain can be taxed more favourably.

You can withdraw up to 5% of your original investment from an insurance policy each year for up to 20 years with no immediate tax charge. This income can be taken monthly, quarterly, every six months or annually. If the annual 5% allowance is not used in one year, it can be carried forward so you can take 10% the following year.

Any withdrawal above 5% is regarded as a gain. It is therefore added to your taxable income in the year in which the policy anniversary falls. For higher rate taxpayers, this is a 20% tax on the gain. There is no additional tax liability for basic rate taxpayers. Once you surrender these 5% withdrawals they can catch up with you. It is not 5% tax free but 5% tax deferred.

If you are prepared to invest regularly for the long term then you can take advantage of tax-free income and gains from a maximum investment plan. There is again a 20% tax charge within the policy. But if you make regular investments into a policy for 10 years every month or year, you can then make a lump sum withdrawal or receive income free of tax. You can take money from the plan at any point after 10 years. One option is to take the 5% withdrawal from a life insurance policy and then invest it in a maximum investment plan. While these maximum investment plans appear attractive, however, you should check the charges. Some are expensive.