There’s an art to cutting up a grapefruit – and an investment bond, says Neil MacLeod, technical specialist, Prudential.
When it comes to cutting things in half there’s usually a right way and a wrong way to do it. If you want to eat your grapefruit with a spoon then cutting across the segments is clearly the way to go.
But it’s important to remember that investment bonds shouldn’t always be treated like grapefruit.
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 and a common end of year tax planning strategy involves splitting bond gains over two tax years. If you are looking to split bond gains for your clients 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.
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 1000 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 in which the policy year end falls.
If you are trying to split your gains over different tax years then you need to ensure you are crystallising the gain you expect.
Take Peter and Paul for example.
- Both have UK investment bonds in which they invested £150,000 on the 01/01/2012.
- Neither have taken any withdrawals and the bonds have grown in value to £250,000.
- Each bond has a tax deferred allowance of £75,000 because they are in their 10th 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 21/22 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 a result of 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 could be taken early next tax year albeit they will review the bond value and any changes to bands and allowances in the March budget.
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 short time until the new tax year begins.
Paul’s adviser surrenders half the bond by encashing 10 segments. This causes an immediate chargeable gain of £50,000 which is assessed in the 20/21 tax year. As a result of the 20% tax credit and top slicing relief there is no further tax to pay and Paul is left with a gain of £50k on the remaining segments which will, all going well be encashed in mid to late April.
Peter’s adviser also encashes half the bond but decides to make the withdrawal of £125,000 across segments. As the withdrawal is taken across segments it doesn’t trigger an immediate gain. Instead the withdrawal uses up the tax deferred allowance of £75,000 (5% x £150,000 x 10 years) and an excess gain of £50,000 will arise at the end of the policy year (31st December 2021).
The problem with Peter’s situation is “the final year rule”. If an excess event and a full surrender event falls in the same tax year then the excess event is ignored. Assuming the bond value remained at £125,000 when he came to make the second encashment this would give rise to a gain on final encashment of £100,000.
As it’s a full surrender the calculation is:
(surrender value + previous withdrawals) less (premiums paid + previous excess gains)
(£125,000 + £125,000) less (£150,000 + crucially!!! £0)
This full gain would be assessed in the 21/22 tax year so would cause the very tax charge he was looking to avoid.
The key fact is the policy year and identifying if the final year rule will apply or not. There are times when withdrawing across segments matters and times when it doesn’t and you need to look at each case individually.
Just like there’s a correct way to cut a grapefruit in half when you want to eat it with a spoon there’s more often than not a correct way to cut a bond gain in half when you need to use two tax years!
[Main image: milana-jovanov-eksRP9DoUyc-unsplash]
