In some respects, Insurance Bond taxation is nice and simple. No income arises for the investor, so no annual self-assessment obligations. Bonds therefore don’t fit naturally into the annual rhythm of the income tax system. Instead, tax is deferred until a chargeable event arises and a gain is calculated on that event. Easy? Yes, in some cases, but as we approach the end of the tax year, where Bond encashments are being contemplated and tax calculations need to be performed, then let’s remind ourselves of the building blocks required to perform those tax calculations. A Bond encashment does, of course, give rise to a chargeable event.
Consider Anna, who is a client living in Manchester. In 2019/20 her salary is £48,400. She has held an Onshore Bond for just over eight years, which she is fully surrendering. Her original premium was £100,000 and the current surrender value is £92,000. She has taken total withdrawals within 5% limits of £32,000.
Step one – Calculate the Bond gain
Anna’s full Bond surrender gives rise to a chargeable event. We need to calculate whether a gain arises on that chargeable event.
| £ | |
| Surrender value | 92,000 |
| Add previous capital payments | 32,000 |
| Less premium paid | (100,000) |
| Less previous gains | Nil |
| Full surrender gain arising in 2019/20 | 24,000 |
Tip
Anna fully surrendered her Bond, which meant that the chargeable event gain arose at the date of encashment. In contrast, where a part surrender occurs, a calculation must be made at the end of the ‘policy’ year’ to see whether a gain has arisen and if so its amount. Any ‘excess’ gain therefore arises at the end of the policy year and not when the part surrender is taken. In that event you need to determine in which tax year does the policy year end.
Step two – Consider the impact of the Bond gain on Anna’s Adjusted Net Income
Without the bond gain, Anna’s only income component is employment income of £48,400. The bond gain of £24,000 will, however, give rise to a further component – savings income. Anna’s total income is therefore £72,400. Assuming no gift aid payments or Relief At Source pension contributions, then her Adjusted Net Income is £72,400. Why is it important that we check a client’s Adjusted Net Income?
- The basic personal allowance is restricted for those where Adjusted Net Income exceeds £100,000
- The high-income child benefit tax charge impacts those with an Adjusted Net Income over £50,000
- The amount of Personal Savings Allowance (PSA) depends on Adjusted Net Income (up to £50,000, the PSA is £1,000, then £500 up to £150,000, then zero.
- The £29,600 income limit for Married Couple’s Allowance where either party was born before 6 April 1935 is based on Adjusted Net Income
Tip
Beware that bond gains in full count towards Adjusted Net Income, not top-sliced gains.
Step three – Calculate Anna’s tax liability before Top Slicing Relief
Income tax liabilities are calculated using fixed order of income rules. In Anna’s case this is relatively straightforward, as she has just two components. Under these rules, we will tax her earnings first and secondly her Onshore Bond gain, which falls within the definition of savings income. Since Anna’s Adjusted Net Income is between £50,000 and £150,000, her Personal Savings Nil Rate Allowance is £500.
| Source | Amount £ | Band £ | Rate% | Tax Due £ |
| Salary | 12,500 | Personal Allowance | 0 | 0 |
| Salary | 35,900 | Basic Rate | 20 | 7,180 |
| Bond gain | 500 | Personal Savings Allowance | 0 | 0 |
| Bond gain | 1,100 | Basic Rate | 20 | 220 |
| Bond gain | 22,400 | Higher Rate | 40 | 8,960 |
| Total | 72,400 | 16,360 |
We will deal with the Onshore Bond ‘tax credit’ in step five.
Further details on the order of income tax are contained here.
Tip
The Personal Allowance (and Blind Person’s Allowance) can be deducted in the way that results in the greatest reduction in a client’s income tax liability. The general rule of thumb is to deduct the maximum personal allowance from non-savings, non-dividend income (e.g. salary), as this component suffers tax at the highest rates and enjoys no 0% bands that may apply to savings and dividend income; also remember that dividends are taxed at a maximum rate of just 38.1%.
Step four – Calculate Top Slicing relief due
The Bond gain straddles basic and higher rate tax, and therefore Top Slicing Relief is available. A full surrender gain is top sliced back to inception, and so Anna’s gain of £24,000 is divided by eight to give a slice of £3,000. Several months ago HMRC updated its Top Slicing Relief guidance to fall into line with tax law (previously it didn’t!) and this is reflected below.
In the Top Slicing calculation, we initially need to calculate Anna’s liability on the full Bond gain. As you can see above, it is £0 + £220 + £8,960 = £9,180. We now deduct a basic rate credit of £4,800 (£20% x £24,000) which produces a figure of £4,380 for ‘Anna’s liability’. Note for reference that counter-intuitively we deduct a basic rate credit, regardless of whether it is an onshore or offshore Bond which means that for a given gain and slice then Top Slicing Relief will be identical whether Onshore or Offshore.
We now need to calculate Anna’s liability on just the £3,000 slice as follows.
| Source | Amount £ | Band £ | Rate% | Tax Due £ |
| Salary | 12,500 | Personal Allowance | 0 | 0 |
| Salary | 35,900 | Basic Rate | 20 | 7,180 |
| Bond slice | 500 | Personal Savings Allowance | 0 | 0 |
| Bond slice | 1,100 | Basic Rate | 20 | 220 |
| Bond slice | 1,400 | Higher Rate | 40 | 560 |
Her liability on the slice is therefore £0 + £220 + £560 = £780. From this figure we deduct £600, comprising the basic rate credit on the slice (£20% x £3,000). The resultant figure of £180 is multiplied by eight (years) to arrive at a figure of £1,440 representing ‘Anna’s liability on the slice’.
The Top Slicing relief due is calculated by deducting ‘Anna’s liability on the slice’ of £1,440 from ‘Anna’s liability’ of £4,380. Anna is therefore entitled to Top Slicing Relief of £2,940.
Tip
When calculating a tax liability before Top Slicing Relief, then the fixed order of tax rules applies. Onshore and Offshore bond gains are slotted in differently in the specified order, with Onshore coming after dividends but Offshore before dividends.
When you calculate Top Slicing Relief itself, then Onshore and Offshore bond gains and slices are treated as the ‘highest part’ of income.
Step Five – Summary of Anna’s tax situation
We know from Step three that Anna’s tax liability before Top Slicing Relief was £16,360. If we then deduct Top Slicing Relief of £2,940, we arrive at a figure of £13,420. That’s not quite the end of the matter, as we now need to deduct the onshore bond ‘tax credit’ of £4,800, so that Anna’s overall tax liability is £8,620. This is necessary, given that gains on Onshore Bonds are not liable to basic rate tax.
Planning
Anna could enhance the benefits of Top Slicing Relief by making a personal pension contribution in 2019/20, which would extend the basic rate band by the gross contribution. Why is that important? Because, less of the gain and less of the slice will then fall into the higher bracket.
For technical resources and a suite of planning tools visit the tax year end hub on PruAdviser.
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