Don’t let chargeable gains harm your clients’ tax position.
It is easy to think that when a client surrenders a UK investment bond that there’s no need to worry about tax, because they’re a basic rate taxpayer.
But of course that’s not always the case; firstly, the top-slice may push them into higher rate tax and secondly, they are still duty bound to report the chargeable gain to HMRC – even though no tax may actually be payable.
There are also other ramifications for basic rate taxpayers, because the chargeable gain will be classed as unearned income and can impact negatively on the policyholder’s personal tax position.
This is because HMRC will initially add the full amount of the chargeable gain to the policyholder’s other income to ascertain their ‘adjusted net income’ – working out their tax bill based on that figure before top-slicing relief is applied.
The message is that an investment bond is an excellent tax-efficient investment, but if a chargeable gain does occur, you should check the following situations.
1. Personal allowance
When a person’s adjusted net income exceeds £100,000 their personal allowance is reduced by £1 for every £2 over that limit.
So if they have income of £102,000 their personal allowance is reduced by £1,000 (£2,000/2) from £11,500 to £10,500. Of course, this means that they may pay more tax on their existing income and in some instances when chargeable gains arise, considerably more.
The following examples illustrate this point.
John has PAYE income of £20,000 and he surrenders a UK bond after 20 years with a chargeable gain of £103,000. Because his adjusted net income is £123,000 for that tax year, his personal allowance is reduced from £11,500 to nil.
The top-slice is still within the basic rate tax band of £33,500 and so there is no additional tax to pay on the chargeable gain from a UK bond but he now receives a tax bill for £2,300 (20 per cent of £11,500) on some of his PAYE income as this is now taxable.
Joanna has PAYE income of £30,000 and she surrenders a UK bond after 20 years with a chargeable gain of £300,000. Because her adjusted net income is £330,000 for that tax year, her personal allowance is also reduced from £11,500 to nil.
Like John, she also now receives a tax bill for £2,300 (20% of £11,500) but more seriously, the top-slice that was below the basic rate tax threshold of £45,000 (personal allowance of £11,500 plus basic rate tax band of £33,500) is now extending into higher rate tax.
When the top-slice of £15,000 is added to her income of £30,000 the total of £45,000 exceeds the revised basic rate tax threshold of £33,500 by £11,500. Higher rate tax is levied on this amount at 20 per cent (there is a basic rate tax credit for UK bonds) giving a tax bill of £2,300 (£11,500 x 20 per cent) for the slice of £15,000.