This case study looks at how top slicing relief can assist in reducing the rate of tax charged.
Nick is a basic-rate taxpayer who has recently relocated to Norfolk to take up a new job. He has been renting accommodation but has now found his dream house in Norwich and is about to realise a substantial gain on an onshore bond to fund a deposit on it.
He is concerned about his potential income tax liability and has asked his adviser to explain the tax situation and outline any further financial planning opportunities.
How a chargeable event gain is taxed
Nick’s adviser explains to him that in broad terms:
- Basic rate taxpayers are not subject to further tax
- Higher rate taxpayers are subject to 20 per cent tax on the gain
- Additional rate taxpayers are subject to 25 per cent tax on the gain
The adviser expands on this by pointing out that since chargeable event gains are generally treated as forming the highest slice of total income a basic rate taxpayer such as Nick can be pushed into higher rate tax bracket. The adviser explains that top slicing relief can assist in reducing the rate of tax charged as it applies a spreading mechanism over the number of complete years that the bond has been held.
Nick’s personal situation
Nick confirms that his income in 2014/15 will be £30,265 (after personal allowances) and he expects to realise a £50,000 gain on his onshore bond, which he has held for 10 complete years.
When top slicing relief is available
The adviser first explains that top slicing relief is available to Nick as he does not pay higher rate tax on his other income (excluding the gain) but when the gain is added he becomes subject to higher rate tax.
The adviser sets out the six-step top slicing procedure used by HMRC.
Top slicing – the HMRC way
- Calculate Nick’s liability ignoring top-slicing relief:
|Salary (after personal allowance)||£30,265|
|Chargeable event gain||£50,000|
|Tax @ 20 per cent on £31,865||£6,373|
|Tax @ 40 per cent on £48,400||£19,360|
(A basic rate credit of £10,000 is available to reduce the overall liability – see below).
- Identify how much of the gain falls into higher rate and multiply it by 20 per cent £48,400 x 20 per cent = £9,680.
- Divide the gain by the number of complete years to calculate the “slice” £50,000 / 10 = £5,000.
- Add the slice onto other taxable income to identify how much falls into higher rate
£5,000 + £30,265 = £35,265. Therefore £3,400 falls into higher rate
- Take the step four portion, multiply it by 20 per cent, then multiply by number of complete years
£3,400 x 20 per cent x 10 = £6,800.
- Calculate top slicing relief by deducting step five from step two
£9,680 – £6,800 = £2,880.
The adviser explains to Nick that his liability after top slicing relief will be the total liability in step one of £25,733 less the top slicing relief in step six of £2,880. That equates to £22,853, and when the basic rate credit of £10,000 is deducted, that reduces his overall liability to £12,853.
Acknowledging that this is a complex issue, Nick’s adviser explain there is a shorter way to consider matters. This simply calculates the additional tax due on the bond gain without quantifying the amount of top slicing relief itself.
Top slicing – the “short” way
Nick has a taxable salary of £30,265. If the top sliced gain of £5,000 (the total gain divided by the number of complete years the bond was held) is added to this figure the total is £35,265. That exceeds the basic rate band by £3,400.
This means that Nick suffers higher-rate tax due on his bond gain of £3,400 x 20 per cent x 10 = £6,800.
If this figure of £6,800 is added to Nick’s tax liability on his salary of £6,053 (£30,265 x 20 per cent), this gives a total of £12,853, which reconciles to the HMRC calculation.
So, if Nick cashes in his bond he will need to pay £6,800 in tax. But his adviser informs him that he can eliminate the liability by making a personal pension contribution.
Pension contribution planning
Currently, Nick’s taxable salary plus the top sliced gain exceeds the basic rate band by £3,400. If Nick pays a net pension contribution of £2,720 then his basic rate band will be extended by £3,400, meaning he will have no higher-rate tax liability on his bond.
This gives Nick an effective rate of tax relief of a whopping 220 per cent.
This is explained by the fact that the pension provider is claiming back £680 from the Government and in addition, Nick’s tax liability is reducing by £6,800 giving a total saving of £7,480 for a gross pension contribution of just £3,400.
Graeme Robb is a technical manager at Prudential