UK resident customers who have or can earn on investment bonds may face an income tax charge. Basic planning with pensions can reduce the impact.
Single premium investment bonds are imposed under taxable events legislation, which means that taxable gains are assessed against income tax rather than capital gains tax (CGT). This can result in taxation of earnings at rates of up to 45%, losing almost half of the “profit”. UK-based or onshore investment bonds offer the bondholder a tax credit of 20% of the gain offsetting corporation tax incurred as part of the insurance envelope. This results in a personal income tax subject to higher and additional rates only.
Understanding the reliefs
There are many reliefs available for billable event gains, but we will focus on the top bracket relief which divides any gain by the full years carried forward to provide an overall or annualized gain figure. This overall gain is used to calculate the tax on the total gain as if your client had acquired it each year to avoid paying higher income tax rates than they normally would.
Although source relief from pension contributions enjoys immediate 20% tax relief under a UK registered pension scheme, higher and additional rate relief is provided by extending the income tax brackets. It works by extending the base rate and the top rate bracket by an amount equivalent to the gross pension contribution (after deduction of 20% at source). For example, if £ 8,000 were put into a source relief scheme, £ 10,000 would be credited to the scheme and the base rate range would drop from £ 37,700 to £ 47,700. This allows more income to be taxed at 20%, thus providing an additional 20% relief to higher rate taxpayers. The same concept exists for the upper rate bracket.
Using the concepts of top bracket relief and income tax bracket extension, simple planning strategies can help your client avoid paying a higher tax rate on a taxable event gain. . Your client must be eligible for source relief from pension contributions (and have sufficient annual allowance) and have sufficient funds to do so. The proceeds from the removal of the bond could of course provide some or all of the money.
The examples below use the 2021/22 allocations and bands. The first shows an onshore bond gain and a simple way to avoid paying additional tax on the gain. And the second shows how a net tax bill of £ 0 on a bond gain can be achieved for a higher rate taxpayer.
Income: £ 45,000
Bond gain: £ 35,000 over 5 years (tax treated as paid £ 7,000)
Without planning this gain would result in income tax after top bracket relief of £ 1,230 as the total gain of £ 7,000 (£ 35,000 / 5) exceeds the base rate range.
By making a source relief from pension contributions of £ 1,000 (£ 1,250 gross) this tax could be avoided while adding £ 1,000 to the pension provision.
It works by expanding the baseband from £ 1,250 to £ 38,950. This is enough to keep the total payout of £ 7,000 within the base price bracket:
Allocations and available brackets
£ 12,570 personal allowance + £ 38,950 base rate bracket + £ 500 personal savings allowance =
£ 52,020 before higher rate payable on bond gain
Total taxable income, including overall gain
£ 45,000 of income + £ 7,000 of overall gain = £ 52,000
By recommending at source relief from pension contributions that is lower than the initial tax bill, your clients could avoid paying any tax on the taxable event gain realized on a UK investment bond.
Income: £ 60,000
Bond gain: £ 20,000 over 5 years (tax treated as paid £ 4,000)
Without planning, this gain would result in income tax after relief of £ 3,000, as the total gain of £ 4,000 (£ 20,000 / 5) is above the base rate range. The personal savings allowance is available in this example but is not sufficient to cover the entire gain.
By providing relief at source of pension contributions of £ 6,000, immediate tax relief is applied to the scheme providing a gross contribution of £ 7,500, providing a tax refund of £ 1,500 into the pension scheme. In addition, the base rate bracket is extended by the gross contribution of £ 7,500, providing an additional £ 7,500 of taxable income at 20% instead of 40% providing a tax saving of £ 1,500.
By recommending relatively modest source relief from pension contributions, your clients could get a net tax position of £ 0 on a taxable event gain realized on a UK investment bond.
Paying tax on an investment is a sign that you have managed your clients’ money well. Sometimes the tax bill is inevitable, but you can add value by providing a well-balanced exit strategy from investing by combining it with contributions to retirement provision. This can avoid the tax or “soften the blow” by recovering it either directly (reduction of tax on other income) or indirectly (applied to a pension scheme).
Shaun Moore is a Tax and Financial Planning Expert at Quilter