Earlier this week I met a new client, who is in an awful tax scenario because of how he drew money from two investment bonds – realistically tax should not have been an issue. The problem was caused by their previous financial adviser not understanding the tax rules and making a dire mistake.
I thought I would write an article on this as it is so common for people to suffer a tax bill when no tax could have been payable – the failing being how the bond is taxed and not drawing the proceeds in the most tax efficient manner.
Remember with an investment bond, the policy is made up of mini-policies so you potentially have more flexibility of how you encash.
There are two sets of rules for tax depending on how you withdraw money –
1. Top Slicing – this is where you draw a proportion of the whole bond equally across all of the mini-policies. The advantage of this is if you draw up to 5% of the original investment, then this is treated as a repayment of capital until such time as you have withdrawn all of your original capital and thereafter assessed to income tax at your marginal rate of tax.
What this means is if you stay within the 5% Rule – you could defer any payment of income tax until another day many years away.
The problem comes if you draw more than this 5%, then the addition is added onto your income to assess the tax liability. So typically, not the best way to withdraw large amounts of capital from then investment bond.
2. Encash whole mini-policies – tax is assessed and payable based on the profit made on each mini-policy.
Scenario 1
Client invests £50,000 in an onshore bond and £50,000 in an offshore bond, both invested just under 5 years ago and he has seen a slight drop in value through the investment to £49,000 for each bond.
Client now draws £90,000 – £45,000 from each bond by an equal apportionment across the policies (Top Slicing)
Problem being anything over the 5% Rule, when encashed in this way will be assessed and taxed as income.
Okay, lets say he has an average income of £25,000 per annum
5% Rule for each complete year – 20% of the original – £10,000 on each bond
Onshore and Offshore bonds – to be assessed against income leading to a further expected tax liability of £19,126
Scenario 2
Exactly the same as scenario 1 except – now draws £90,000 – £45,000 from each bond by an cashing individual mini-policies
The good news – each investment bond has seen a slight decline in value. Tax is only payable on profits.
Onshore and Offshore bonds – to be assessed against income leading to a further expected tax liability of £Nil
Summary
The point being – if you are withdrawing a fixed regular amount of say up to 5% per annum of the original investment – then Top Slicing can be an effective tool.
If, however you are withdrawing a capital amount there are typically better approaches.
Please be aware that this only touches on the taxation of investment bonds – this is actually a very complicated area but the basics are clear and sound.
CARE NEEDS TO BE TAKEN AND KNOWLEDGE APPLYED
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