Tax disasters lie in wait for DIYers

The courts have allowed a right of appeal to have a partial withdrawal from an offshore bond reversed and treated as a full surrender of segments. If successful the appeal could see a US$1.2m (£778,000) chargeable gain (the bond was denominated in US dollars) almost wiped out completely.

It is easy for a prospective client to recognise the need for advice when he has a cheque in hand ready to invest. Faced with a variety of tax wrappers and a seemingly infinite number of funds, the choices can be daunting. Turning to an adviser who can make sense of it all is the logical solution.

What about when he wants some of his money back? At this point is the need for advice quite as obvious?

Ideally, he will understand the need for regular reviews of his investments. But some people will always take the view: “It’s my money – why must I go through an adviser to get at it?”

Arguably the need for advice is potentially greater when taking money out of investments. All the valuable investment advice provided at the outset can count for nothing if there are tax charges as a result of taking bond withdrawals in the wrong way, or cramming a retirement’s worth of taxable income into a single tax year.

Joost Lobler must wish he had taken advice before approaching his offshore bond provider to request a withdrawal

Joost Lobler must wish he had taken advice before approaching his offshore bond provider to request a withdrawal. Mr Lobler, a UK-resident Dutch national, took out an offshore bond shortly before making a large partial withdrawal to fund a property purchase. The resulting chargeable gain left him facing a tax bill of US$560,000 (£360,000).

Mr Lobler questioned the fairness of the tax result through the courts. He had received, at best, only modest growth over the short period the money was invested and had withdrawn less than he had originally invested.

The result would have been so different if he had received the right advice before making the withdrawals. It would have saved a lengthy legal battle and no doubt a huge amount of stress.

How the money is taken from the bond can make a huge difference to the eventual tax position. The bond provider’s surrender request form offered three options for withdrawing some of the funds invested in the bond:

1. Part surrender across all segments and funds.

2. Part surrender across all segments from specific funds.

3. Full surrender of individual segments.

Without advice, Mr Lobler was playing Russian roulette with only one chamber empty. Having chosen option 2, Mr Lobler was left with a tax bill of over half a million US dollars.

Had the withdrawal been taken as full surrender of individual segments (option 3), the tax due would have been a fraction of the bill HMRC presented him with. But that does not mean it will be the right choice for everyone, nor does it mean that every case in which the least favourable option is chosen will be overturned in the courts. And that is why advice is so important.

The new pension freedoms could be a temptation too far for some. But at what cost?

Stripping out the fund in one go will mean an entire retirement’s worth of taxable income is shoe-horned into a single tax year. Tax allowances may be wasted and it could result in an income tax bill which is potentially higher than the tax relief received when contributions were paid. Plus it brings the value of the pension back into the estate for IHT.

Many clients taking an ad hoc payment (which is not all tax-free cash) from their pension will be treated as if they were starting the first in a series of monthly withdrawals – and taxed as if they were going to continue making monthly withdrawals for the remainder of the tax year. This can lead to an initial overpayment of tax which may need to be reclaimed.

HMRC insists that providers must deduct tax from pension income under PAYE. When an ad hoc payment is taken as opposed to a regular monthly income, even a relatively modest withdrawal could incur some income tax at the additional rate of 45 per cent.

For example, Liam crystallises £40,000, taking a tax-free lump sum of £10,000, and drawing pension income of £30,000 under flexi-access drawdown. Using an emergency tax code, the pension income would be taxed as follows:

So of the £40,000 crystallised, he actually receives the net amount of £28,052.25, and his pension income is effectively taxed at a rate of 39.8 per cent.

Any overpaid tax will eventually be repaid, although it could take up to 12 months for it to be sorted out through PAYE. Alternatively, the client could make a reclaim directly from HMRC which could cut the waiting time down to around six weeks.

While overpaid tax due to emergency tax codes can be reclaimed, reclaiming overpaid tax due to a failure to seek advice is not quite as simple.

Laws and tax rules may change in the future, and the information here is based on our understanding as at June 2015. Your client’s personal circumstances also have an impact on tax treatment.

Dave Downie is technical manager at Standard Life

Key points

A recent court case has highlighted the importance of seeking advice before accessing funds.

Valuable investment advice at the outset can count for nothing if there are tax charges as a result of taking bond withdrawals in the wrong way.

It could take up to 12 months for overpaid tax to be sorted out through PAYE.