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Strategic withdrawal

Last week, I reminded you all – as if you needed reminding – of the adviser dilemma or opportunity that is the bonds versus collectives debate.

Since the radical changes to capital gains tax were first announced in the pre-Budget report and then confirmed in the Budget and ensuing Finance Bill, much attention has been given to the respective tax implications on final encashment of an investment. Less attention seems to have been paid to the difference in the tax treatment of part encashments or withdrawals from collectives and bonds respectively and that is odd when you consider that a reasonable number of investors will probably not encash their investment all at once.

Those who do will need to be aware of all the tax planning strategies that are capable of being employed to minimise tax. I will look at these another time.

This week, I would like to take a look at the rules for part encashments from bonds and collectives and try to draw some highlevel conclusions. The 5 per cent withdrawal rule is often highlighted as one of the features of investment bonds which direct investment in collective funds cannot offer. Most investment bond brochures would identify this as a simple way to draw down benefits from the bond with no tax charge, at the time of withdrawal at least.

The ability to draw regular sums with nothing to report on a tax return has obvious appeal and the ability to do this for up to 20 years may seem like tax nirvana for many. This tax-free income is likely to turn out to be tax-deferred income but many investors, especially those who expect to live for less than 20 years, may just think never mind.

The rules for part encashment of collectives are less well known and certainly less well understood, which could have something to do with the fact that they are slightly more complicated. Despite this, in practice, regular part encashments of collective funds will rarely produce gains that need to be reported on a tax return and will rarely give rise to any tax liability.

The basic rule for reporting gains is that you only need to do so if:

l You disposed of chargeable assets which were worth more than four times the annual exemption (£38,400 in 2008/09) orl Your chargeable gains before losses are more than the annual exemption (£9,600 in 2008/09) orl You want to claim an allowable capital loss or make any other capital gains tax claim or election for the year.

For 2007/08, the chargeable gains that trigger reporting are those after the indexation allowance but before taper relief, both of which are abolished from 2008/09.

How about the calculation to ascertain whether a taxable gain arises and, of course, whether it needs to be reported? For a partial encashment in 2008/09, the calculation of the gain is:

Amount realised minus (amount realised divided by current value) multiplied by (capital plus reinvested income remaining).

For example, if an investment of £100,000 is made and after one year it has grown to £105,500, including £1,500 reinvested income, then a £5,000 withdrawal would produce a gain of:£5,000 minus (£5,000 divided by £105,500) multiplied by (£100,000 plus £1,500) = £189.57.

The balance of the payment – £4,810.43 – would be treated as a partial return of capital and reinvested income.

The tricky bit is to ascertain which part of the amount taken should be treated as a non-taxable return of the originally invested capital. That is what the above calculations are all about.

In year two, if the same 5.5 per cent overall investment return is achieved, the investment will be worth £106,028, of which £1,508 will be reinvested income. The CGT calculation for another £5,000 encashment will be:£5,000 minus (£5,000 divided by £106,028) multiplied by (£100,000 plus £1,500 minus £4,810.43 plus £1,508) = £369.26.

What we see over a period of regular withdrawals is a gradual erosion of the original capital base, with the result that an increasing amount of a fixed withdrawal is likely to be taxed as gain.

Unless Parliament decides otherwise, the annual CGT exemption is automatically increased in April each year by RPI inflation to the previous September, with the result rounded up to the higher £100. On a 2.5 per cent inflation assumption, that means the exemption will be £16,300 in 20 years time.

The sting in the tail of regular withdrawals from a collective is that, on final encashment, there can be a big capital gain because much of the original capital and reinvested income has been accounted for in earlier withdrawals.

In the above example, the value of the holding immediately after the 20th withdrawal would be £117,434 and the capital gain would be £56,142. Most of this gain would attract 18 per cent CGT.

However, if the investment is held until death, all gains are washed out. This factor is very important for those considering investment in a dynastic sense. This CGT wipe-out on death can really complement inheritance tax planning when collectives are used, say, in combination with trusts, to minimise or avoid IHT, possibly even retaining some kind of IHT-inoffensive access to settled funds for the settlor.


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