One of your investment bonds is due to mature later this year. It’s showing a healthy gain and as a result you’re expecting a stiff tax bill. What steps can you take to reduce it?
Investment bond gains
For tax purposes gains made on insurance investment bonds are totted up and taxed in full in the tax year in which they are wholly surrendered (cashed in). This is the position even if you have made withdrawals from the bond, known as partial surrenders, within the annual tax-free amount (5% of the original sum you invested).
Example. Peter invested £20,000 in an insurance bond ten years ago. It’s performed pretty well and at maturity it’s worth £42,000. The gain of £22,000 is added to Peter’s other taxable income for 2021/22, say £55,000 (that means he’s in the higher rate tax bracket), and so the tax on the bond will be at 40% less a credit allowed by HMRC for 20% basic rate tax deemed to have been deducted at source (this applies to UK bonds only). This means the tax bill on the bond gain is £4,400, i.e. £22,000 x (40%-20%).
Top slicing relief
HMRC allows a measure of tax relief to compensate for the gain, which arose over ten years, being taxed all one year. The relief goes by the exotic name of top slicing relief (TSR). The bad news for Peter is that TSR won’t help him as it compares the tax payable on the whole gain for 2021/22 with what would be payable if this was divided (sliced) by the number of years the bond was held, i.e. ten.
Trap. Where your tax rate is the same if you add just a slice or the whole gain, you won’t benefit from TSR, unless you haven’t used your “savings allowance” (see The next step ). In Peter’s case, adding £22,000 or £2,200 makes no difference as both fall into the higher rate tax band because of his other income for 2021/22.
Tip. If Peter was able to reduce his other income in anticipation of cashing in his bond so that it falls below the higher rate tax bracket he could make TSR work for him. This would be the case if his main income was salary and dividends from his own company. However, if this isn’t possible all is not lost.
Increased outgoings
In order to make TSR work Peter can raise the point at which the higher rate tax bracket applies. This can have a similar effect as reducing his income.
Tip. If Peter pays a pension contribution (assuming he has not paid any in 2021/22 so far), on or before 5 April 2022, it will extend the amount of income on which he is taxed at the basic rate and so reduce that liable to higher rates. If he judged the amount of pension contribution right it will result in significant TSR.
Tax relief as super rates
By paying the optimum amount into a pension scheme so that you maximise the effect of TSR you can, in effect, achieve tax relief equal to around 65% of your contribution. For example, paying a pension contribution of £20,000 could, taking account of TSR, reduce the cost to you after tax relief to just £7,000 (see The next step ).
Tip. Making gift aid payments has a similar effect as pension contributions.
If you’re liable to higher rate tax because of an investment bond gain, reducing your other income can allow you to benefit from top slicing relief which will reduce your tax bill. Alternatively, paying a pension contribution can have the same result by giving you tax relief at around 65% of the amount of your contribution.
This article has been reproduced by kind permission of Indicator – FL Memo Ltd. For details of their tax-saving products please visit www.indicator-flm.co.uk or call 01233 653500.