An investment bond allows access to a tax efficient income as it is possible to withdraw an amount equal to 5% of the original investment each year without incurring an immediate tax liability. This can continue until the original investment has been returned and so can potentially continue for 20 years. Withdrawals of 4% can continue for 25 years and so on.
This can be very useful for clients who have a personal allowance that is reduced by investment income or interest payments as it still provides them with an income, but removes it from their income tax calculation.
These are called the personal allowance ‘traps’; let us consider both of these:
The age allowance trap
Although being phased out by the current Government, every individual born before 6 April 1948 is entitled to a higher personal allowance, but they are only able to receive this full amount if their income does not exceed £26,100 in the tax year.
When an individual’s income does exceed the £26,100 threshold, the personal allowance is reduced by £1 for every £2 of income. As a safety net, HMRC will never allow the personal allowance to fall below the standard amount of £9,440 unless their income exceeds £100,000.
Therefore, an individual born between 5 April 1938 and 6 April 1948 with income of over £28,220 would only receive the standard personal allowance as would an individual born before 6 April 1938 with an income of £28,540 or more.
Let us consider two individuals, Tom and Barbara, born on 5 April 1948:
• Tom has pension income of £26,100
| Gross income | Tax | Net income | |
| Personal allowance | £10,500 | 0 | £10,500 |
| Basic rate tax @ 20% | £15,600 | £3,120 | £12,480 |
| Total | £26,100 | £3,120 | £22,980 |
• Barbara has pension income of £26,100 and £2,120 from deposit account interest
Personal allowance is reduced, £10,500 less (£28,220 - £26,100) / 2 = £9,440
| Gross income | Tax | Net income | |
| Personal allowance | £9,440 | 0 | £9,440 |
| Basic rate tax @ 20% | £18,780 | £3,756 | £15,024 |
| Total | £28,220 | £3,756 | £24,464 |
As Barbara receives a small income of £2,120 from a deposit account her tax liability increases by £636 (being £3,756 less £3,150), meaning that the interest is effectively taxed at 30%.
By placing the deposit into an investment bond and making use of the tax deferred withdrawals, Barbara can remove this amount from her income tax calculation and maximise her age-related personal allowance.
The high earner personal allowance trap
Individuals with an income in excess of £100,000 have their personal allowance reduced by £1 for every £2 of income over £100,000, potentially reducing it to zero. Therefore no personal allowance would be allowed for anyone earning over £118,880.
Again, let us consider two individuals:
• Eric has an annual salary of £100,000
| Gross income | Tax | Net income | |
| Personal allowance | £9,440 | 0 | £9,440 |
| Basic rate tax @ 20% | £32,010 | £6,402 | £25,608 |
| Higher rate tax @ 40% | £58,550 | £23,420 | £35,130 |
| Total | £100,000 | £29,822 | £70,178 |
• Joan has an annual salary of £100,000 and £18,880 from deposit account interest
| Gross income | Tax | Net income | |
| Personal allowance | 0 | 0 | 0 |
| Basic rate tax @ 20% | £32,010 | £6,402 | £25,608 |
| Higher rate tax @ 40% | £86,870 | £34,748 | £52,122 |
| Total | £118,880 | £41,150 | £77,730 |
As Joan receives an additional income of £18,880 from a deposit account her tax liability increases by £11,328 (being £34,748 less £23,420), meaning that the portfolio income is effectively taxed at 60%.
Again, if this deposit account was held under an investment bond making use of the tax deferred withdrawals she would benefit from a full personal allowance and pay less tax.
When considering a client’s total income, it can be made up from a variety of sources including employment or self-employment, pensions or annuities, unit trusts, open-ended investment company (OEIC), bank interest and rental income. By replacing some of this income with bond withdrawals it is possible to reduce a client’s income tax liability, making full use of the allowances available.
Neil Jones is Technical Project Manager at Canada Life
