As the end of the tax year fast approaches so does the beginning of the new one. Tax year end isn’t simply a question of using allowances before the end of the tax year, it’s also about looking forward to see what planning can be done next tax year, says Neil Macleod, Senior Technical Manager, Specialist Business Support at M&G Wealth.
A common end of year tax planning strategy involves splitting bond gains over two tax years where encashment in a single tax year would cause an unnecessary tax liability. This is all well and good but there are pitfalls to watch out for.
One of the useful features of investment bonds is that they are made up of a number of segments. There are bonds which only have one segment so it’s always wise to check with the provider first about the policy but it’s more likely that your client’s bond will be made up of 10, 100 or even a 1,000 separate segments or “mini-bonds”. Each segment is identical in terms of the amount invested, surrender value, previous withdrawals, and previous excess gains. This provides good planning opportunities on encashment but you need to be mindful that encashing half the bond doesn’t always equate to crystallising half the gain.
There are two ways to make a withdrawal from an investment bond.
If you surrender full segments it results in a chargeable event on the date the encashment takes place and the gain is assessed in the tax year the withdrawal occurs. The formula for calculating gains on full surrender of segments is:
(surrender value + previous withdrawals) less (premiums paid + previous excess gains)
If instead of encashing segments you make a “partial withdrawal” an equal amount is taken from each segment. Partial withdrawals will only cause a chargeable event if the withdrawal exceeds the tax deferred allowance available. Where you do exceed the tax deferred allowance, there is an “excess gain” at the end of the policy year and importantly this is taxed in the tax year the policy year ends.
If you are trying to split your gains over different tax years then you need to ensure that firstly you are crystallising the gain you expect and secondly the chargeable event dates fall in the correct tax years.
Take Peter and Paul for example.
- Both have UK investment bonds in which they invested £150,000 on the 01/01/2016.
- Neither have taken any withdrawals and the bonds have grown in value to £250,000.
- Each bond has a tax deferred allowance of £82,500 because they are in their 11th policy year.
- On full encashment there would be a chargeable gain of £100,000.
Both Peter and Paul have earned income for the current tax year of £45,000 and this is expected to be the same in the 2026/27 tax year.
Their advisers do the maths and realise that crystallising a gain this tax year of £50,000 will ensure their client’s adjusted net income won’t exceed £100,000 and their personal allowance for the tax year will remain intact.
Also, as the bond has been in force for 10 full years, taking into account top slicing relief and the onshore bond tax credit, when a slice of £5,000 is added to their other income there will be no further tax to pay on the gain. In theory this should leave a similar sized gain which can be take early next tax year albeit they will review the bond value when it comes to the final encashment.
After discussions with their respective advisers both client’s agree to splitting the encashment over two tax years to try to avoid paying any tax as a result of the chargeable gain, especially as it’s only a few months until the new tax year begins.
Paul’s adviser surrenders 10 segments which causes an immediate chargeable gain of £50,000 which is assessed in the 2025/26 tax year. As a result of the 20% tax credit and top slicing relief there is no further to tax to pay and leaves Paul with a gain of approximately £50k on the remaining segments which will, all going well be encashed in mid to late April.
Peter’s adviser on the other hand decides to make the withdrawal of £125,000 across segments. As this is taken across segments it does not trigger an immediate gain. Instead as the withdrawal exceeds the tax deferred allowance by £42,500, an excess gain of £42,500 will arise at the end of the policy year (31 December 2026) Importantly, if the remaining value of the bond is subsequently encashed in the 2026/27 tax year the excess gain is ignored. If the bond were to remain at its current value this means the gain calculation on final encashment would be:
(surrender value + previous withdrawals) less (premiums paid + previous excess gains)
(£125,000 + £125,000) less (£150,000 + £0) = £100,000
The £100,000 gain would result in Peter’s full personal allowance being lost. As a consequence of this and because part of the slice would fall into the higher rate band, Peter would have additional tax to pay of £12,434 on encashment.
Staggering bond gains over multiple tax years can be a very useful planning strategy. Remember however, if you’re adopting this approach you need to ensure the first encashment is done correctly or you could be in for a shock next tax year when you come to encash the rest of the bond.
