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Bond excess gains: how to calculate the income tax due

Advisers must consider a client’s income tax position after the excess gain occurs

bond excess gains

Advisers need to consider a particular client’s income tax position after any bond excess gains occur. This case study explains the process

Ethel is a retired lady who has an active social life and enjoys catching up with her friends. At one of her coffee mornings, her friend Jane mentions her new adviser has advised her to invest in various life assurance bonds so she can take advantage of the tax-free regular payments for the next 20 years.

Ethel had thought that she was well informed about her own bonds but she did not realise the regular withdrawals will seemingly stop after 20 years. Ethel has a number of similar bonds and some of them will shortly be reaching their 20th anniversary. She is very worried her regular payments, upon which she relies, will come to an end, so she makes an appointment with her own adviser.

The advice
Ethel’s adviser explains it is a myth that regular payments under a bond will stop after 20 years. These payments are tax deferred, not tax-free.

A life assurance bond enables the owner to take up to 5 per cent tax deferred withdrawals across all of the policy segments per year, until the original capital is exhausted. If a client has been taking 5 per cent withdrawals since the start of the bond these will continue after 20 years but they will then be assessable to income tax.

If a client has been taking less than the maximum 5 per cent then the regular withdrawals will continue until the original amount paid in has been used up before being assessed for tax. At the end of every policy anniversary of the bond it is tested to make sure the owner has not taken out more than the rolled up 5 per cent.

If they have exceeded this, there will be a chargeable event called an excess event. The insurance company that has provided the bond will then issue a chargeable event certificate and there may be some income tax to pay depending on the client’s income tax position.

Most bonds do not have a time period attached to them and can continue indefinitely until the last life assured dies.

Ethel’s adviser will have to take a look at her income tax position after the excess gain occurs to see if the gain will cause her to pay any tax.

The maths
To calculate a gain, the adviser adds the full gain to the individual’s income to test for the reduction in personal allowance. If the resulting figure is more than £100,000, the adviser has to reduce their personal allowance £1 for every £2 over. This may mean that an individual will have to pay basic rate tax on their other income.

The next step is to divide the gain by the full number of years the plan has been in force. Ethel has a UK bond and the rules for working out the slice on an excess event can seem confusing.

The client’s income per year
Pension income £8,500
Bond 1 1/10/1997 5% £8,000
Bond 2 1/5/1999 5% £15,000
Bond 2 1/8/2009 5% £17,500
Total £49,000

Source: Prudential

Basically, to work out the slice the adviser can only count the number of years to when the last excess event took place. Thus, in year 21, she will be able to slice back to the start of the bond but thereafter there will be no slice.

Each year thereafter the full amount of the withdrawal payment will be added to Ethel’s other income to see if it takes her into the higher rate tax bracket.

See the table below for Ethel’s “income” per year. Although Ethel’s income is £49,000, most of this is being taken in the form of tax deferred capital withdrawals, so Ethel’s total for income tax and personal allowance purposes is £8,500. When the excess event of £8,000 occurs, it will be nowhere near the limit for the personal allowance reduction, neither will it cause Ethel to be pushed into higher rate tax if her income remains the same.

This is reassuring for Ethel as she can continue to take the same level of withdrawal without it causing her an income tax charge each year.

In fact, this is working to Ethel’s advantage because, when she eventually surrenders her bond, she will be able to deduct the previous excess events from her final gain figure, therefore potentially reducing the amount that may be liable for tax.

Helen O’Hagan is technical manager at Prudential


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