“Top slicing relief” can reduce higher rate tax on a chargeable event gain by allowing the bondholder to spread the investment gains over the number of years the bond has been held. It is available to non taxpayers, starting rate taxpayers or basic rate taxpayers who, after adding chargeable event gains to their income, become higher rate taxpayers.
When an investment bond is finally encashed, there may be a liability for income tax on any amount over and above the level of your original investment, in other words the growth. This tax may be mitigated by applying “top slicing” relief. The gain is divided by the number of complete policy years the bond has been held for to give an “annual equivalent”. This is then added to total income received by the bondholder in the year of encashment to determine whether there is any additional tax to pay. To do this you need to identify how much of the “annual equivalent” falls in the higher and, if applicable, the additional rate tax band. If the profit slice pushes the bondholder into the higher rate tax threshold, there would be additional tax of 20% to pay on the amount falling in the higher rate tax bracket. The amount of total tax payable is then calculated by multiplying the amount of tax on the profit slice by the number of policy years the bond has been held for.
We can see that the tax liability resulting from a partial or complete surrender is deferred until the chargeable event occurs, as opposed to being taxed immediately. This is efficient from a taxation point of view, since you are only taxed when a chargeable event occurs, as opposed to being taxed each year, at source, as you would have been for savings interest or share dividends. This delay in paying tax means the underlying assets within the investment bond should benefit from growth which would otherwise have been curtailed had the tax been due earlier.
Onshore vs Offshore bonds and top slicing
Care needs to be taken when applying top slicing relief to an offshore bond, since there is a slight difference with how it is calculated compared to an onshore bond. Partial surrenders from onshore bonds are taken back to any previous chargeable event or, if there were no previous chargeable events, to the start date of the bond. Conversely, if a partial surrender is made from an offshore bond, the top slice is always taken back to the start date of the policy.
With careful planning it can be possible to time the encashment of an investment bond to coincide with a tax year where income is less than in previous years- for instance if a retiree became a basic rate tax payer when previously they were paying higher rate tax, a bond encashment in the year of being a basic rate taxpayer would be advantageous and could mean not having to pay any additional tax on surrender. Alternatively, it may be possible to make partial surrenders straddling several tax years to ensure none of the top sliced gain pushes the bondholder into the higher rate tax threshold. This is because if a basic rate taxpayer triggers a chargeable event, leading to the gain being added to their income but keeping them within the basic rate tax threshold, there is no need to calculate top slicing relief, since there is no additional tax to pay.
It should be noted that if a bondholder was already a higher rate taxpayer prior to the triggering of a chargeable event, top slicing relief cannot be used to reduce their liability to tax. Similarly, Trustees paying tax at 50% cannot benefit from top slicing relief. It is possible, however, for a higher rate tax payer who becomes an additional rate taxpayer to apply top slicing to their chargeable gain to prevent all of it being liable to additional rate tax.
Example of applying Top Slicing Relief
To demonstrate how top slicing relief can be applied to investment bonds, it may help to use a worked example:
A 63 year old decides to encash their onshore investment bond, having held it for 8 complete policy years. The investment bond was originally purchased for £100,000 and now has a surrender value of £150,000 – hence a gain of £50,000 has been made. The bondholder has not made any withdrawals or part surrenders during the time they held the bond. In the year of full surrender, the bondholder had earned income, after the deduction of all allowances (ie the Personal Allowance) which was £500 less than where the higher rate tax threshold (ie 40% tax) begins. We can calculate the tax liability by following the procedure below:
1. Deduct the original investment amount (£100,000) from the surrender value of the bond (£150,000) to give the gain of £50,000. Divide this gain by the number of complete policy years the bond has been held for: £50,000 / 8 = £6,250.
2. Add the top sliced gain to income to see how much falls into the Higher Rate tax threshold. We know from the above that £500 falls into the basic rate tax threshold, with the remainder being taxed at 40%. So, of the £6,250 gain, subtract £500 (which is the balance of the basic rate band) to give us £5,750 which will be taxed at the difference between basic rate tax (20%) and higher rate tax (40%).
So £5,750 taxed at 20% gives £1,150.00
3. Multiply this amount by the top slice multiplier used earlier, which is 8 to reflect the number of years the bond has been held for.
£1,144.00 x 8 = £9,200.00
This is the amount of tax liable.
4. To find the net proceeds of the investment bond, deduct this amount from the gain of £50,000.
£50,000 – £9,200.00 = £40,800.00
Reporting top sliced gains
When completing a self assessment taxation return it is important to know the order of priority which a top sliced investment bond calculation has relative to other sources of taxable income. This can have a bearing on what rates of tax apply to the life policy gains. Life policy gains need to be taxed at the top of the self assessment computation. This means they are above income derived from dividends, savings, pension income, rental income and employed or self employed earnings. Consequently, the 0% rate of tax which applies to income derived from savings may not be eligible to apply against investment bond gains if it has already been offset against other sources of income.
Care also needs to be taken when calculating the Personal Allowance for higher earners. A gain from a surrendered investment bond may push an individual into the Personal Allowance Withdrawal band where the Personal Allowance is reduced by £2 for every £1 of earnings above the threshold at which the Personal Allowance is reduced, which is currently £100,000. When calculating the reduction of the Personal Allowance it is not possible to apply top slicing relief to the investment bond gain. The whole of the bond gain is included in the adjusted net income figure. This is not an issue for those earning £123,700 or more since they have already had their Personal Allowance reduced to zero.
Mitigating taxation from investment bonds
There are other tax planning strategies which can be used in conjunction with top slicing relief to further mitigate tax due. These include assignment to spouses and making a pension contribution which extends the basic rate tax threshold and allows more of the top slice to avoid higher rate income tax. These ideas are discussed in more depth in our section “Using investment bonds for tax planning”.