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‘Savage trap’ to catch basic-rate taxpayers

Basic-rate taxpayers could be caught in “a savage tax trap” as a result of Budget proposals to scrap the income tax personal allowance.

Fidelity FundsNetwork says insurers are putting offshore bonds forward as the answer to problems caused by the 50 per cent tax rate and the cap on pension tax relief.

From 2010/11, people earning more than £100,000 will start to lose their personal allowance. This is likely to create a 60 per cent marginal rate of tax for income falling between £100,000 and £112,950.

But head of trusts and tax planning Paul Kennedy says: “There is even more devil in this detail that could affect anyone investing in an insurance bond, even a basic-rate taxpayer.

“The Budget notes intimate 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 a low-earner gets a big payout from an insurance bond, top-slicing relief limits the tax payable and ensures they remain a basic rate taxpayer. But Kennedy says it appears that when determining whether the personal allowance is lost, the whole gain, not just the top-sliced gain, will be added to income.

He says: “This creates a marginal rate of tax of 30 per cent for an offshore bond even though this investor is a low-earning basic rate taxpayer.

“Somebody earning say £45,000, will face a similar problem. 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.”

Anand Associates financial architect James Brook says: “I agree there is a tax trap but this is a proposal and by the time it is debated and we have had an election, a lot could change.

“If you are using tax breaks for long-term investment planning there is a danger the goalposts could be moved in the future. Advisers have to make sure clients are aware that tax benefits are not in any way guaranteed.”

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