10th December 2013
Canada Life: A tax deferred is a tax saved
Question:
Brian is an employee who has inherited a lump sum of £100,000. Although he is a higher rate taxpayer at present, as a member of his employer’s defined contribution pension scheme, he thinks he will be a basic rate taxpayer when he retires. He seeks an investment which allows him access before retirement if required, but which defers tax liabilities until he is a basic rate taxpayer.
Answer:
If Brian were to take out an onshore investment bond, there would be no personal liability to income tax until a chargeable event occurred and the proceeds will be exempt from capital gains tax. This could mean that, as long as there was no chargeable event until after Brian’s retirement, there may be no income tax liability.
As far as access before retirement is concerned, Brian would be able to take partial withdrawals from the bond within the 5% tax-deferred facility. This allowance is cumulative meaning that, if Brian took no withdrawals for five years, say, he could take up to 6 x 5% x £100,000 = £30,000 in year six without triggering an immediate liability to income tax. However, when the bond is fully encashed, any prior partial withdrawals will need to be taken into account. If this occurs when Brian is a basic rate taxpayer, any gain could escape income tax, even if Brian was a higher rate taxpayer when the previous partial withdrawal was taken.
To illustrate how this works, let’s assume that Brian does take a £30,000 partial withdrawal in year six, when he is still a higher rate taxpayer, and then fully encashes the bond for £150,000 11 years later, a couple of years after his retirement. How will the amount of the gain be calculated?
The formula to be used in these circumstances is:
(Surrender value + previous withdrawals) less (premium + previous excesses)
The reference to “previous excesses” is to previous partial withdrawals that exceeded the cumulative 5% allowance. In Brian’s case, there have been none of these, so the calculation is:
(£150,000 + £30,000) less (£100,000 + £0) = £80,000
The bond has been in force for 16 complete years, meaning that the £80,000 gain can be divided by 16, resulting in the top-sliced gain being only £5,000. If Brian’s income plus £5,000 is under the higher rate threshold, this will result in there being no personal liability to income tax on the whole £80,000 gain, since his basic rate liability will be covered by the 20% tax credit on the gain.
However, there are two potential difficulties with this strategy. In determining whether Brian’s income exceeds the income limit (currently £26,100) for the purposes of age allowance, the whole gain of £80,000 has to be added to his other income, not the top-sliced gain of £5,000. This suggests that Brian’s age allowance would be eliminated completely, resulting in an increased basic rate liability. Similarly, the whole £80,000 has to be added to Brian’s income to ascertain whether he has exceeded the income limit (currently £100,000) for the purposes of the basic personal allowance.
However, the age allowance problem will soon disappear. The current age allowances (£10,500 for clients born before 6 April 1948 and £10,660 for clients born before 6 April 1938) are now frozen until such time as the basic personal allowance (£10,000 for 2014/15) is increased in future to exceed these figures. When this happens, every client will have the same personal allowance, no matter how old they are, and the age allowance trap will disappear. It seems highly likely that this will be the case when Brian’s bond is fully encashed. And the issue regarding the basic personal allowance could be managed by fully encashing, say, half the bond segments in one tax year and the other half in the following tax year, to ensure that the income limit at that time is not exceeded.
Paul Thompson
Tax & Estate Planning Consultant
Canada Life Limited
01707 422999
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