To understand this strategy, we need to look at each component independently and then fit them together. The AEA has seen a dramatic fall in value in real terms following the introduction of the flat rate of CGT this year. It still offers up to £1,728 of tax savings but for reinvestment strategies, the costs may erode some or all of the tax benefit achieved.
If the cost of using the AEA for reinvestment purposes is, say, 1 per cent of a portfolio, for a £200,000 portfolio the exercise will actually cost the client £272 more than the tax benefit available. However, as an exit strategy, realising gains to supplement income, the AEA offers a real benefit.
The calculation of the gain arising on a withdrawal or part-disposal is slightly more technical. The calculation process is as follows:
Gain = A less I x A ÷ (A+B) where I is the amount of the investment, A is the amount withdrawn and B is the value of the investment after withdrawal. This is slightly more complex than the 5 per cent a year of original investment for 20 years that is available for investment bond clients but it is certainly worth getting to grips with.
The idea is to calculate what amount of any withdrawal is actual gain and thus taxable. Let us look at how it works in an example using a client who invests £300,000 in an Oeic. They have full use of the AEA which escalates at 2 per cent annually and the value of the investment grows at 6 per cent a year after charges. The client requires a withdrawal of capital of £15,000 (5 per cent) each year.
The gain in year one would be £15,000 less £300,000 x £15,000 ÷ (£15,000 + £303,000) = £15,000 less £14,151 = £849.
The sum of £14,151 is the original capital represented by the withdrawal of £15,000. As the £849 gain is less than the AEA, no CGT is payable.
The impact of the AEA escalating year on year and the relatively small gains arising from the capital withdrawn means that this is a highly tax-efficient way to release capital on a regular basis. In year two, the gain would be £15,000 less (£300,000 – £14,151) x £15,000 ÷ (£15,000 + £306,180) = £15,000 less £13,350 = £1,650. If the assumptions remained constant due to escalation on the AEA, withdrawals at this level would never become liable to tax.
Let us consider capital withdrawals of 6.66 per cent. At 6 per cent growth, no tax is payable and the fund is not exhausted until the 40th year. A slight fall in the growth assumption to 5 per cent will creates tax-free withdrawal into the 29th year.
If an adviser considers adopting this strategy, there are a number of factors that need to be addressed. Significant growth or decline in value in any particular year means the adviser will need to review the calculations to ensure the tax-efficiency of this strategy is maintained.
Reporting to HM Revenue & Customs should not be an issue, as gains will remain below the AEA. However, it is worth remembering that capital withdrawals which exceed four times the AEA, even with no taxable gain, need to be reported through the self-assessment process.
I have taken no account of income yield, focusing only on capital growth. Any income arising (interest or dividend) would give rise to an income tax charge, even where accumulation units or shares are held. By investing in more growth orientated funds, income could be kept to a minimum but, as I have often said, tax is not the sole driver of the fund choice or wrapper selection.
Using the allowances and exemptions available could mean a client’s future planning strategy will revolve around multiple product wrappers, each offering their own unique features and benefits. Maximising the tax breaks afforded to clients by Parliament will demonstrate the added value that quality financial advice delivers.
Colin Jelley is head of tax and financial planning at Skandia