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Jacqueline Clezy: Bond gains – know your tax implications

Advisers must be careful not to let tapered annual allowance rules catch them out

Mhairi lives and manages her own company in Brighton. Each year, she draws a salary of £10,000, dividends of £85,000, and her company makes an employer pension contribution of £40,000.

She has an onshore bond, invested for 10 full years, and has a total gain of £50,000 over the 20 segments in force. Each segment is worth £10,000, making the total value of the bond £200,000. She would like to access at least some of this to meet a capital need.

Mhairi believes she has a good grasp of tax rules, working out her potential tax due at £18,248.75 before any bond surrender, and £33,150 assuming full surrender. However, when including the bond, her accountant prepares a figure of £40,775. She asks for a breakdown.

Tax charge
It becomes clear Mhairi has not realised she will have an annual allowance charge. She will be affected by a tapered annual allowance if she fully encashes the bond, because her threshold income would exceed £110,000 and her adjusted income would exceed £150,000. The table below provides a quick reminder of how to work out the relevant numbers.

Mhairi’s threshold income is her total taxable income: £145,000. To work out adjusted income, add on employer pension contributions of £40,000, so £185,000. As she has exceeded both threshold and adjusted income, she loses £1 of standard annual allowance for every £2 of adjusted income over £150,000 – £17,500 (£185,000 – £150,000/2) – leaving a £22,500 (£40,000 – £17,500) allowance for the current tax year.

With no unused annual allowance to carry forward, there is an excess of £17,500 (£40,000 paid – £22,500 allowance). The annual allowance charge adds this excess to Mhairi’s other income. This means the first £5,000 is charged at 40 per cent and the remaining £12,500 at 45 per cent. The total charge is £7,625.

Assuming Mhairi’s total taxable income is £145,000 means she loses all her personal allowance too.

You lose £1 of the £11,850 allowance for every £2 of taxable income in excess of £100,000.

Top-slicing relief does not apply to tapered annual allowance or loss of personal allowance calculations. You have to use the full gain to ascertain the position for both.

Tapered annual allowance planning
Mhairi’s full bond surrender calculation would look like this:

  • Total income: £95,000 (adjusted net income is £145,000)
  • Subtract tax due: £40,775
  • Add bond surrender value: £200,000
  • Net: £254,225

Providing her threshold income is not above £110,000, a tapered annual allowance will not apply. She is restricted in the amount of personal pension contribution she can pay to receive tax relief, as only her salary of £10,000 is relevant earnings.

Additionally, employer contributions are using her annual allowance. Perhaps she could choose to take a smaller withdrawal from her bond?

Fully surrendering six of the 20 segments would release £60,000, with a chargeable event of £15,000, making her total income £110,000, and thus avoiding a tapered annual allowance:

  • Total income: £95,000 (adjusted net income is £110,000)
  • Subtract tax due: £23,067.50
  • Add bond surrender value: £60,000
  • Net: £131,932.50

Mhairi reduces her net income for the year by £122,292.50 to avoid the tapered annual allowance and the subsequent annual allowance charge.

She also retains £140,000 within the bond for future years.

By taking a partial bond surrender of £60,000, she only increases her tax liability by £4,818.75.

How low can you go?
If you can manipulate threshold income down to £110,000 to avoid a tapered annual allowance, could you also make a pension contribution to reduce adjusted net income to £100,000 to regain a personal allowance?

In some scenarios it is worth considering, as usually the effective rate of tax relief in the personal allowance trap is 60 per cent. It will not work for Mhairi as you would create an annual allowance excess, as she has no carry-forward. The rate for the tax charge (40 per cent) will be higher than the tax relief gained – due to the order of taxation, you only save the tax rate on dividends.

Do not let the tapered annual allowance rules catch you out. Stay on top of in-year tax plans and, if the tax consequences are undesirable, find a new path to get your client to a better place.

Jacqueline Clezy is technical manager at Prudential



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