When a client invests a lump sum it is important to consider the flexibility and facilities available under the tax wrapper used. This can help a client minimise tax during the life of the investment and any that may potentially be payable on final encashment.
An investment bond, as a life policy, can offer many benefits including 5% annual tax deferred withdrawals, tax efficient switching, top-slicing relief and so on.
When these are utilised and combined it can allow a number of different potential tax efficient exit strategies for a client. And as a bond is a non-income producing asset it is very easy for a client or trust to administer as unless there is a chargeable gain, it is not included in any tax calculations.
Some of the benefits are suggested in this article and can be used to help reduce any chargeable gain or the tax payable.
Tax deferred withdrawals
Legislation allows an amount equal to 5% of the original investment to be withdrawn each year and HMRC classes it as a return of capital. Therefore, no gain exists and there is no immediate tax liability. This can continue until an amount equal to the original investment is returned. It also applies to any additional investments paid into the same policy.
This allowance is cumulative and therefore any unused amounts are available in later years. So, where no income is taken, 10% is available in year two, 15% is available in year three and so on.
This allows a client to make withdrawals to supplement an income, perhaps in retirement, or to withdraw lump sums periodically as and when they are needed.
Assignments
As a bond is a life insurance policy, it is possible to gift it to another person without generating a tax liability.
The client is therefore able to pass the investment onto another person, such as a son or daughter, for them to own. This can be very beneficial for succession planning and estate planning, meaning that the investment can be handed down through generations.
When a chargeable gain arises the tax liability is on the new owner and if they are a lower rate tax payer than the original owner, this can be a way of reducing a potential tax liability.
Timing
If a chargeable event occurs and the bond finishes, such as on surrender or the death of the last life assured, any gain is assessed in the tax year in which the event occurs.
If the policy continues, for example when making withdrawals over and above the 5% allowance, the assessment is done in the tax-year in which the next policy anniversary falls. This could be the following tax year.
Example
A client invests in a bond on 1 March 2010 and a takes an excess withdrawal on 31 March 2013 causing a chargeable event. Despite this event occurring in the 2012/13 tax year, the next policy anniversary is in the 2013/14 tax year and it is in this year that the chargeable gain will be assessed.
This time delay can provide the client sufficient time to manage income levels to help reduce or minimise any potential tax liability.
Managing income levels
When a chargeable gain occurs the tax liability is based on the client’s income in the tax-year of assessment, irrespective of the client’s income levels during the investment term.
This can be very useful where a client expects to see their income fall into a lower tax band when they may want to benefit from the policy proceeds. This could be a drop in income at retirement, or a business owner with the ability to adjust their income.
If a higher rate taxpayer can reduce their income to the basic rate threshold, then this could potentially halve the tax liability.
If income levels cannot be manipulated, it is possible to reduce taxable income by making contributions to an approved pension scheme. Such contributions extend the basic rate tax band by the gross amount of the contributions. A client may still see a drop in their net income but it allows for funds to be diverted from HMRC to a pension scheme, from which the client can benefit from at a later date.
Example
A basic rate taxpayer has a chargeable gain of £5,000 from an onshore bond, of which £2,000 would fall within the higher rate tax band. Income tax of £400 will be payable.
A gross pension contribution of £2,000 would extend the basic rate tax band to cover the chargeable gain, avoiding tax on the gain.
Segmentation
Many bonds are written as a series of identical policies. This can provide added flexibility when a client wants to withdraw funds or assign benefits to other individuals.
Where a lump sum is required from the bond and this is in excess of the 5% allowance, the clients have the ability to surrender individual polices rather than take the money as a withdrawal. This can be beneficial as any amounts taken over the 5% allowance treated as a chargeable gain, irrespective of the policy value.
Example
If a £100,000 investment bond had been in force for four and a half years, a withdrawal of £60,000 would generate a chargeable gain of £35,000 even if the policy value was only £99,000.
Bonds are generally written as a series of identical sub-policies or segments. It is possible to maximize the 5% withdrawals and surrender segments to meet any balance of capital required. A chargeable gain could still exist on the segment surrenders, but this could be much lower than before.
Top-slicing
When a chargeable gain occurs it is possible to divide the gain by the number of complete policy years over which it has been made to determine the tax rate applicable.
This is relevant when a gain takes a client into a higher tax bracket, meaning that a basic rate taxpayer could avoid a higher rate of tax and a higher rate tax payer would avoid additional rate tax.
Example
A chargeable gain of £15,000 made over a 10-year period would give an annualised gain of £15,000/ 10 = £1,500.
Overall
These are just some of the characteristics and benefits a bond can offer an investor that can lead to many opportunities in tax planning.
Many clients will be able to take advantage of one of the strategies outlined above, showing the worth of investment bonds in an overall investment strategy.
Neil Jones is Technical Project Manager at Canada Life
