Tax planning: How to exit a bond – Part II
9 December 2018
In the second part of her articles, Kim Jarvis, technical manager, Canada Life says when using a UK bond, the exit is not all about tax
There are many factors besides tax to take into account when choosing a tax wrapper, and these may impact on access. Investment bonds provide flexibility in access and the ability to spread the return, which can provide some advantages over collectives, while also enabling a range of strategies that can help reduce the chargeable gain or the tax payable.
As basic rate income tax has already been paid within a UK bond, when a gain arises further tax is only payable if this takes the policyholder’s income into a higher or additional rate tax. In this case, top slicing relief is available to reduce or mitigate any liability by spreading the gain over the number of complete years the bond has been held for – although it is not available when calculating the personal allowance. This is relevant when a gain would take a client into a higher tax bracket, meaning that a basic rate taxpayer could avoid a higher rate of tax.
Also, if a chargeable gain occurs, the tax liability is based on the policyholder’s income in the tax year of assessment, irrespective of the policyholder’s income levels during the bond’s term.
This rule can be very useful where a client expects to see their income fall into a lower tax band when they may want to supplement their income with money from the bond. Examples of this could include a drop in income at retirement, or where a business owner has the ability to adjust their income. So, if the opportunity arises for a higher rate taxpayer to reduce their income to the basic rate threshold then this could potentially halve the tax liability.
Making pension contributions
Tax relief is available at a policyholder’s highest marginal rate on pension contributions up to 100% of relevant earnings – that is, on any earned income excluding pension income, most rental income and on dividends, although annual allowances will apply.
If income levels cannot be manipulated, it might be possible to reduce taxable income by making pension contributions. Where contributions are made under the ‘relief at source’ method, any basic rate tax relief is given within the pension. For higher and additional rates of tax relief this is achieved by increasing the policyholder’s basic rate band by the amount of the grossed up contributions. This has the effect of shifting the higher and additional rate tax bands so that part or all of the policyholder’s income falls into the basic rate band.
Whilst a policyholder may see a drop in net income, it allows income to be moved from a 40% tax bracket into a 20%, and a 45% tax bracket into a 40%.
An investment bond can be assigned to another owner and this is a way of directing assets to others for them to own. This mechanism allows the tax point of an investment bond to be deflected away from the original owner to a new owner, ultimately enabling the assets to be assigned in the most tax-efficient way under the circumstances.
The benefit of being able to assign, or change policy ownership, is that the transaction is not a chargeable event for the purposes of income tax, provided that it is a genuine gift and has not been assigned for money or money’s worth.
The new owner is then treated as owning the bond from outset. This allows them to make use of the available cumulative 5% tax-deferred allowance or even surrender the bond using their own tax position.
So, if the policyholder has a spouse/civil partner, or a child over the age of 18, then the bond or individual policies can be assigned to them before any chargeable event occurs. The eventual gain would then be taxable on the new owner, who may pay a lower rate of income tax.
But care should be taken when a policy is assigned to a new owner that the original owner does not benefit from any further proceeds, as this circular arrangement might attract the attention of HMRC – they may look at the overall transaction rather than the individual steps and apply tax accordingly.
If a UK resident is planning on working abroad and then returning, any gains made whilst the policyholder is non-resident are taken into account in any subsequent calculation. For example, any withdrawals in excess of 5% taken whilst non-resident will count as a credit in the chargeable calculation after they become UK resident again.
The important message here is that UK bonds should not be dismissed simply because there is tax within the fund. There are many factors besides tax to take into account when choosing a tax wrapper. Every client will have different objectives. In some instances, a collective investment may be more beneficial than a bond and vice versa. Some clients may be better served by investing in both tax wrappers, thereby achieving even more flexibility in their investment strategy.
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