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Using investment bonds for tax planning

Investment bonds can be highly versatile investment vehicles and can provide invaluable opportunities for tax planning. Taxation mitigation strategies involving investment bonds are explored below and they include use of assignment, pension funding and segmentation.

Assigning a bond to a spouse

Where the policyholder is a higher-rate taxpayer and the spouse is a basic rate or non-taxpayer, it creates a valuable tax planning opportunity. This is because the investment bond can be transferred by means of a deed of assignment by the higher rate taxpayer to the non taxpaying spouse without triggering a “chargeable event“. This would mean that further liability to tax can be avoided following the assignment.

Care needs to be taken since the deed of assignment needs to be executed before any chargeable event takes place. It is also essential that the assignment is not for money or money’s worth.

Making a pension contribution to reduce tax from a bond

To mitigate chargeable gains arising from surrendering an investment bond, making a personal pension contribution can reduce taxable income prior to performing the ‘top-slicing calculations’, which determine to what extent higher rate tax is due on any chargeable gain. The pension contribution can move the top-sliced gain from being subject to higher rate tax to below the extended basic rate tax limit. The grossed up pension contribution can extend the basic rate tax band so that after top-slicing, a chargeable event gain can fall into the basic rate tax band. It is also possible to use a pension contribution to move a top-sliced gain down from the additional rate of income tax to the higher rate.

Here are the four steps you would need to take to reduce tax incurred from triggering a chargeable event from an investment bond surrender by making a pension contribution:

  1. Identify all taxable income assessable to the higher rate tax bands.
  2. Calculate the top sliced gain from the investment bond.
  3. Work out the pension contribution needed to move some or all of the top sliced gain into the lower tax band.
  4. Make sure the personal pension contribution is made in the same tax year as the bond gain is taxed.

Segmentation of investment bonds to reduce taxable gains

In some circumstances, it may be more tax efficient to fully surrender individual segments held within an investment bond rather than take cumulative withdrawals across all segments of the bond. Where cumulative 5% allowances are exceeded then the chargeable gain which results is determined by the amount originally invested, as opposed to the current valuation of the investment bond. In this scenario, you could find that a chargeable gain occurs even if the investment has made a loss. A significant partial withdrawal in excess of the 5% cumulative allowance can create a chargeable event gain which could have been avoided by surrendering segments from the bond instead.

The difference between surrendering segments of an investment bond as against using thee cumulative 5% yearly allowances can be seen using the following scenario:

A policyholder invested £200,000 into an investment bond three years ago. The investment bond was split into 100 segments, so each segment was worth £2,000. If the bondholder chose to withdraw 5% from each segment, this would equate to £100 per segment, and would total £10,000 of the amount originally invested.

If the bondholder wishes to withdraw £100,000  when the bond is worth £220,000, there are two ways they could do this:

1. Taking 5% cumulative withdrawals

If the bondholder were to take a partial surrender across all segments, the chargeable gain would be calculated as:

£100,000 – £30,000 (3 years of £10,000) = £70,000 The “top sliced gain” would be £70,000/3 = £23,333.33

In this example, the current valuation of the bond is irrelevant since we are using the amount originally invested to determine the cumulative 5% withdrawals.

2. Full surrender of segments

Alternatively, the bondholder could surrender in full sufficient segments to release the required £100,000. Using the current valuation at the time of encashment, each segment is valued at £2,200. Surrendering in full 46 segments would yield £101,200, slightly more than the £100,000 required.

The chargeable gain for each segment is the current valuation per segment (£2,200) less the original value of each segment when the investment bond was first taken out (£2,000) = £200

The full surrender of 46 segments gives a chargeable gain of 46 x £200 = £9,200.

This is then divided by the number of full policy years the segments were in force, which is 3 to give a Top Slice of £3,066.66.

You can see, therefore, that there is a significant difference in tax efficiency between the two methods of withdrawing 5% cumulative withdrawals against surrendering in full enough segments to release the required amount.

It is possible to combine surrendering segments with taking 5% per annum cumulative withdrawals from an investment bond to achieve maximum tax efficiency when making a partial or full surrender. For more on this, please refer to our worked example of how to combine surrendering segments with 5% per annum cumulative withdrawals.

Avoiding the Age Allowance Trap

Age Allowance is a tax benefit in the form of an enhanced Personal Allowance given to those aged 65 or over which is reduced by £1 for every £2 of income which exceeds it until it drops back to the same level as the ordinary Personal Allowance. This allowance is enhanced further for those aged 75 or over. It should be noted that Age Allowance is currently frozen and so it is likely to be overtaken by the standard Personal Allowance, which is not means tested.

When an investment bond is fully surrendered, any profit made (including the 5% withdrawals) will be added to the income in that final year. Depending on how much the profit is and how much your income is, this could wipe out any higher age-related tax allowance in the year you cash in your bond. Please note it is only the Age Allowance in the year of encashment which may be adversely effected, taking 5% withdrawals from the bond each year does not count as income which could reduce Age Allowance provided the 5% yearly withdrawals have not exceeded 20 years, in which case they could count against Age Allowance from year 21 onwards.

Care needs to be taken when surrendering or partially surrendering an investment bond and it may be necessary to make partial surrenders in different tax years or wait until your taxable income does not jeopardise any age related personal allowance once gains are added.

Investment bonds can be used to preserve the Age Allowance for income seekers who would see their Age Allowance reduced if they invested in alternative assets outside of a bond wrapper, such as deposit funds paying them interest or took dividend income from unit trusts or OEICs outside an ISA or bond. Since both deposit funds and unit trusts/ OEICs are available within investment bonds, this presents tax planning opportunities to those aged 65 or over who are looking to mitigate income tax.

Avoiding the Personal Allowance Trap

The loss of the personal allowance when income exceeds £100,000 introduced a comparable issue to the ‘age allowance trap’ outlined above. Under current rules, the personal allowance is reduced at the rate of £1 for every £2 an individual’s taxable income exceeds £100,000 a year. Withdrawals from the bond do not count towards the £100,000 threshold, but as with the age related allowances, any chargeable gains (ie on death, full surrender or withdrawals in excess of the cumulative 5% yearly allowances) will be added to income when a chargeable event gain arises.

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