When choosing an investment wrapper for a client, it is important to consider the future exit strategy. Managing an effective exit strategy can help reduce or even remove any tax liability.
Unlike unit trusts and Oeics, investment bonds (onshore and offshore) benefit from tax deferral. The potential tax liability exists when chargeable gain arises -a profit is not a profit until it is outside of the policy.
There are a number of strategies, some of which are suggested below, that can be used to help reduce the chargeable gain or the tax payable. First, we should note the differences between onshore and offshore bonds.
Onshore or offshore?
In this article, we will only be looking at the taxation on exit.
An onshore bond pays tax within the fund deemed to be equivalent to basic-rate tax. An offshore bond has no such allowance. Any gains are taxable at the client’s highest rate. Because of this, if the encashment value is the same (which, in practice, it should not be) the tax payable with the onshore bond is marginally lower.
It must be remembered that an offshore bond can benefit from gross roll-up, greater investment choice and so on.
5 per cent allowance
Under an onshore or offshore investment bond, up to 5 per cent of the original investment can be withdrawn each year and HM Revenue & Customs classes it as a return of capital and no gain exists.
If unused, this allowance accumu-lates, and where no income is taken, 10 per cent is available in year two, 15 per cent in year three and so on.
Where a withdrawal in excess of the 5 per cent allowance is required, the use of policy segments can be beneficial. This is because any withdrawals over the 5 per cent allowance are treated as a chargeable gain, irrespective of the policy value.
If a £100,000 investment bond had been in force for four and a half years, a withdrawal of £60,000 would generate a chargeable gain of £35,000 even if the policy value was only £99,000.
Bonds are generally written as a series of identical sub-policies or segments. It is possible to maximise the 5 per cent withdrawals and surrender segments to meet any balance of capital required. A chargeable gain could still exist on the segment surrenders.
If a chargeable event occurs at the end of a bond, such as on full surrender, then the gain is assessed in the tax year in which the event occurs.
If the policy continues, for example when making excessive withdrawals, the assessment is done in the tax-year in which the next policy anniversary falls. This could be the following tax year and can provide time to manage income levels.
When a chargeable gain occurs it is possible to divide the gain by the number of complete policy years over which it has been made.
This is relevant when a gain takes a client into a higher tax bracket, meaning that a basic-rate taxpayer could avoid a higher rate of tax.
For example, a chargeable gain of £15,000 made over a 10-year period would give an annualised gain of £15,000/ 10 = £1,500.
Reducing the level of income
When a chargeable gain occurs the tax liability is based on the client’s income in the tax-year of assessment, irrespective of the client’s income levels during the investment term.
This can be very useful where a client expects to see their income fall into a lower tax band when they may want to benefit from the policy proceeds. This could be a drop in income at retirement, or a business owner with the ability to adjust their income.
If a higher-rate taxpayer can reduce their income to the basic rate threshold, then this could potentially halve the tax liability.
Making pension contributions
If income levels cannot be manipulated, it is possible to reduce taxable income by making contributions to an approved pension scheme. The amount of the basic-rate tax band is extended by gross pension contributions.
A client may still see a drop in net income but it allows for funds to be diverted from HMRC to a pension scheme and allows the benefit of tax relief.
Example: onshore bond for higher-rate taxpayer
- A basic-rate taxpayer has a charge- – eable gain of £5,000, of which £2,000 would fall within the higher-rate tax band.
- Income tax of £400 will be payable.
- A gross pension contribution of £2,000 would extend the basic-rate tax band to cover the chargeable gain, avoiding tax on the gain.
As a bond is a life insurance policy, it is possible to assign it to another person.
If the bondholder has a spouse or child over the age of 18 then the policy or segments can be assigned to them before any chargeable event occurs. The eventual gain would then be taxable on the assignee, who may pay a lower rate of income tax.
If a bondholder is planning to work abroad and then return, being non-resident for tax purposes in the interim, any gain is reduced by the ratio of days of non-UK residence and days of UK residence.
For example, if a bondholder had a policy for 10 years (3,650 days) and was non-resident for two years (730 days), any chargeable gain would be reduced by one-fifth (ignoring leap years).
Any gains made while the bondholder is non-resident are taken into account in any subsequent calculation, for example, any withdrawals in excess of 5 per cent taken whilst non-resident, will count as a credit in the chargeable-gain calculation after they become UK-resident again.
It can be seen that the tax-deferral characteristics of investment bonds lead them to many opportunities in tax planning. Many clients will be able to take advantage of one of the strategies outlined above, showing the worth of investment bonds in an overall investment strategy.