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One size does not fit all

It seems to me that whenever we have a Budget, whatever the tax changes, the life insurance industry declares the solution is to “do an insurance bond”. I bet you a pound to a penny that whatever changes we see in 2010 the answer to the problem will be to “do an insurance bond”.

Don’t get me wrong, insurance bonds have a place. Some of their attributes may be relevant to those about to face tax at 50 per cent, whether individuals or trustees. They may be useful for those who need to consider alternative strategies for retirement because of the cap on pension tax relief.

I do not wish to knock either insurance bonds or the insurance industry, I simply question the wisdom of telling the audience that, whatever happens, a bond is the answer.

Over the past few weeks I have witnessed a plethora of articles on how the issues caused by a 50 per cent tax rate and cap on pensions tax relief can all be solved with an offshore bond. I recom-mend that you have a read as there is some good stuff. But for the sake of credibility, you need the other side of the story too, which is that the new legislation creates a potentially savage tax trap that might catch even basic-rate taxpayers.

From 2010/11, those with incomes above £100,000 will start to lose their personal income tax allowance and face taxation levels unseen in a generation.

The allowances will be reduced by £1 for every £2 of income above the limit, reducing to nil. Based on the current personal allowance, this will create a 60 per cent marginal rate of tax for income falling between £100,000 and £112,950, making the UK’s one of the highest rates of tax in the developed world.

There is, however, even more devil in this detail that could affect anyone investing in an insurance bond – even a basic-rate taxpayer.

At first glance, you might think the new rules will only affect high earners, but that is not so. We must await the final legislation, but the Budget notes intimate that the test to see whether you lose your personal allowance will be similar to that used for “age allowance”.

This could mean that investors who are earning way below £100,000 have to pay 60 per cent tax on part of their policy gains and even basic-rate taxpayers could face an effective charge of 30 per cent.

Where an otherwise low earner receives a large payout from an insurance bond, a “top-slicing” relief limits the tax payable. Take as an example an investor earning £12,950 who, after investing for 10 years, receives a payout with a gain of £100,000. Despite this large payout, top-slicing ensures they remain a basic-rate taxpayer.

However, it appears that for the purposes of determining whether the personal allowance is lost, the whole gain, not just the top-sliced gain, will be added to income.

In the above example, the total income would be £112,950 for the purposes of determining the allowance and the whole allowance will be lost in that year, leading to an additional tax charge of £1,295. This creates a marginal rate of tax of 30 per cent for an offshore bond and an additional 10 per cent for an onshore bond (which will have already suffered tax at source), even though this investor is otherwise a low-earning basic-rate taxpayer for all other purposes.

Someone who is already a higher-rate taxpayer earning, say, £45,000, will face a similar problem despite being below the £100,000 earnings limit.

A large gain in one year will wipe out their personal allowance, creating an additional tax charge of £2,590, which is a marginal rate of tax of 60 per cent for an offshore bond and 40 per cent for an onshore bond (which will have already suffered tax at source).

Therefore, while it is true that the 5 per cent annual withdrawal allowance may be useful for somebody earning around £100,000 that wants an “income” year by year, there is a sting in the tail which could catch high earners and even those with incomes well below £100,000.

The other fundamental point is that insurance bonds are subject to income tax. So if as a higher earner or trustee your rate of tax is 50 per cent then, prima facie, that is the bill you are going to face on all the growth from your insurance bond.

Again, we can see how the 5 per cent allowance could be useful year by year but the sting is that a 50 per cent tax charge is around the corner. Fine if you fled the country when cashing in but most will not have and will face the hit.

Imagine losing 50 or 60 per cent of a capital gain when the same capital gain would have been taxed at only 18 per cent or less with a collective or even zero with a pool of Isas. I agree that the 5 per cent allowance for an insurance bond might be helpful to some in marginal positions but you have got to watch the eventual sting in the tail and take that into account.

What is indisputable is that tax planning can play a huge part in determining what the investor gets back and this year’s Budget shows why professional advice is so important. With the annual CGT allowance now at £10,100 and the rate of capital gains tax just 18 per cent, collectives and capital gains tax considerations must form part of mainstream investment advice.

Leaping on the back of a Budget to automatically extol the virtues of a single product, whatever that product may be, runs the risk of simply not being credible. A measured response would restore confidence.

All tax wrappers have some virtues but none are perfect for every case. Both the onshore and offshore insurance bonds can be useful tax wrappers in the right circumstances but they are not the foil to every tax change, every year. If you want your message to be respected, you have got to first respect the audience.


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