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End of year tax planning: Calculating bond taxation – with case study

24 February 2020

In the approach to the end of the tax year, the Prudential Technical Team take us through the calculations around insurance bond taxation. 

In some respects, Insurance Bond taxation is nice and simple. No income arises for the investor, so no annual self-assessment obligations. Bonds therefore don’t fit naturally into the annual rhythm of the income tax system.

Instead, tax is deferred until a chargeable event arises and a gain is calculated on that event. Easy? Yes, in some cases, but as we approach the end of the tax year, where Bond encashments are being contemplated and tax calculations need to be performed, then let’s remind ourselves of the building blocks required to perform those tax calculations. A Bond encashment does of course give rise to a chargeable event.

Case study

Consider Anna who is a client living in Manchester. In 2019/20 her salary is £48,400. She has held an Onshore Bond for just over eight years which she is fully surrendering. Her original premium was £100,000 and the current surrender value is £92,000. She has taken total withdrawals within 5% limits of £32,000.

Step one – Calculate the Bond gain

Anna’s full Bond surrender gives rise to a chargeable event.  We need to calculate whether a gain arises on that chargeable event.

Tip

Anna fully surrendered her Bond which meant that the chargeable event gain arose at the date of encashment. In contrast, where a part surrender occurs, a calculation must be made at the end of the ‘policy’ year’ to see whether a gain has arisen and if so its amount. Any ‘excess’ gain therefore arises at the end of the policy year and not when the part surrender is taken. In that event you need to determine in which tax year does the policy year end.

Step two – Consider the impact of the Bond gain on Anna’s Adjusted Net Income

Without the bond gain, Anna’s only income component is employment income of £48,400. The bond gain of £24,000 will however give rise to a further component – savings income. Anna’s total income is therefore £72,400. Assuming no gift aid payments or relief at source pension contributions then her Adjusted Net Income is £72,400. Why is it important that we check a client’s Adjusted Net Income?

  • The basic personal allowance is restricted for those where Adjusted Net Income exceeds £100,000
  • The high-income child benefit tax charge impacts those with an Adjusted Net Income over £50,000
  • The amount of Personal Savings ‘Allowance’ (PSA) depends on Adjusted Net Income (up to £50,000, the PSA is £1,000 then £500 up to £150,000 then zero.
  • The £29,600 income limit for Married Couples ‘Allowance’ where either party born before 6 April 1935 is based on Adjusted Net Income.

Tip

Beware that bond gains in full count towards Adjusted Net Income, not top sliced gains.

Step three – Calculate Anna’s tax liability before Top Slicing Relief

Income tax liabilities are calculated using fixed order of income rules. In Anna’s case this is relatively straightforward as she has just two components. Under these rules, we will tax her earnings first and secondly her Onshore Bond gain which falls within the definition of savings income. Since Anna’s Adjusted Net Income is between £50,000 and £150,000, her Personal Savings Nil Rate ‘Allowance’ is £500.

We will deal with the Onshore Bond ‘tax credit’ in step five.

Further details on the order of income tax are contained here.

Tip

The Personal Allowance (and Blind Person’s Allowance) can be deducted in the way which results in the greatest reduction in a client’s income tax liability. The general rule of thumb is to deduct the maximum personal allowance from non-savings, non-dividend income (e.g. salary) as this component suffers tax at the highest rates and enjoys no 0% bands which may apply to savings and dividend income; also remember that dividends are taxed at a maximum rate of just 38.1%.

Step four – Calculate Top Slicing relief due

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