View more on these topics

# Case study: Deferring tax when investing a windfall

The problem:

Brian is an employee who has inherited a lump sum of £100,000. He is a higher rate taxpayer at present but as a member of his employer’s defined contribution pension scheme, he thinks he will be a basic rate taxpayer when he retires. He needs an investment which allows him access before retirement if required, but which defers tax liabilities until he is a basic rate taxpayer.

The solution:

If Brian were to take out an onshore investment bond, there would be no personal liability to income tax until a chargeable event occurred and the proceeds will be exempt from capital gains tax.  This could mean that as long as there was no chargeable event until after Brian’s retirement, there may be no income tax liability.

Brian could take partial withdrawals from the bond within the 5 per cent tax-deferred facility if he needed access to the investment before retirement. This allowance is cumulative so that if, for example, Brian took no withdrawals for five years, he could take up to £30,000 in year six (six times 5 per cent times £100,000) without triggering an immediate liability to income tax.

When the bond is fully encashed, any prior partial withdrawals will be taken into account.  If this occurs when Brian is a basic rate taxpayer, any gain could escape income tax, even if Brian was a higher rate taxpayer when the previous partial withdrawal was taken.

To illustrate how this works, let’s assume that Brian does take a £30,000 partial withdrawal in year six, when he is still a higher rate taxpayer, then fully encashes the bond for £150,000 11 years later – a couple of years after his retirement.  How will the amount of the gain be calculated?

The formula to be used in these circumstances is: surrender value + previous withdrawals less premium + previous excesses

Previous excesses refers to previous partial withdrawals that have exceeded the cumulative 5 per cent allowance.  In Brian’s case, there have been none, so the calculation is: £150,000 + £30,000 less £100,000 + £0 = £80,000.

As the bond has been in force for 16 complete years, the £80,000 gain can be divided by 16, resulting in the top-sliced gain being only £5,000.  If Brian’s income plus £5,000 is under the higher rate threshold, this will result in there being no personal liability to income tax on the whole £80,000 gain, as his basic rate liability will be covered by the 20 per cent tax credit on the gain.

There are two potential difficulties with this strategy. In determining whether Brian’s income exceeds the income limit  – currently £26,100 – for the purposes of age allowance, the whole gain of £80,000 has to be added to his other income, not the top-sliced gain of £5,000.  This suggests that Brian’s age allowance would be eliminated completely, resulting in an increased basic rate liability.  Similarly, the whole £80,000 has to be added to Brian’s income to ascertain whether he has exceeded the income limit – currently £100,000 – for the purposes of the basic personal allowance.

The age allowance problem will soon disappear.  The current age allowances of £10,500 for clients born before April 6, 1948 and £10,660 for clients born before April 6, 1938 are now frozen until the basic personal allowance – £10,000 for 2014/15 – is increased in future to exceed these figures.  When this happens, every client will have the same personal allowance, no matter how old they are, and the age allowance trap will disappear. It seems highly likely that this will be the case when Brian’s bond is fully encashed.

The potential difficulty with the basic personal allowance could be managed by fully encashing, for example, half the bond segments in one tax year and the other half in the following tax year to ensure that the income limit is not exceeded at that time.

Paul Thompson is tax & estate planning consultant at Canada Life

News and expert analysis straight to your inbox