Bonds for higher rate taxpayers
The taxation of dividend income means that Investment Bonds can be highly tax efficient investments for rate taxpayers who wish to invest in equity linked funds. They are also beneficial for the higher rate taxpayer that may require partial access to their investment in the future. In this Bulletin we look at the tax efficient qualities of investment bonds, the 5% withdrawal rule and the opportunities that exist to minimise tax on final encashment.
Facts and analysis
It is widely accepted that investing for income in a portfolio that is then reinvested reduces overall risk and over the long term is an important driver of growth. The tax position for an investor holding shares or collectives producing dividend income depends on the investor’s rate tax and can be summarised as follows:
- There is a dividend allowance of £1,000 in 2023/24
- For dividends in excess of £1,000:
- Non-taxpayer; no tax is payable
- Basic rate taxpayer; a tax liability of 8.75%
- Higher rate taxpayer; a tax liability of 33.75%
- Additional rate taxpayer; a tax liability of 39.35%
For 2023/24 a person will be a higher rate taxpayer if his taxable income (i.e. net of allowances and deductions) exceeds £50,270 and is less than £125,140. Persons in this position will not pay tax on the first £1,000 of dividends, and will pay tax at 33.75% on the excess over £1,000.
For example, David receives a dividend of £6,000. He is a higher rate taxpayer having other taxable income (after all deductions) of £60,000. His tax liability will be calculated as follows:
|First £1,000 @ 0%
|Tax at 33.75%
|Net dividend retained (a)-(b)
David will have to inform HM Revenue & Customs of his receipt of this dividend income and, under self assessment, pay higher rate tax by the 31 January following the tax year in which he received the dividend income. So, for example, if he received the dividend income in tax year 2023/24, he would need to pay the tax by 31 January 2025 at the latest, or earlier if required to pay by instalments. . Many higher rate taxpaying investors do not need extra income and so will simply put dividend income into a bank account with a view to later reinvestment. The key issues for the higher rate taxpayer who is receiving the dividend income are therefore:
- the dividend income in excess of £1,000 is taxable at 33.75%
- eventual reinvestment of the dividend income in excess of £1,000 will be after it has suffered additional tax thus restricting long-term growth prospects
- if the dividend is reinvested in the fund automatically the tax payer will still have to pay the additional tax
- the dividend income in excess of £1,000 gives rise to increased administration for the taxpayer in that he needs to:
- inform the HMRC about it
- pay higher rate tax on it
- and physically reinvest it (unless it is automatically reinvested)
An investment in an Investment Bond can avoid many of the above problems that relate to dividend income and offers the following advantages to the investor:
- A bond is non-income producing, this means that there is no automatic tax charge on the investment each year. In effect the investment accumulates in value net of any insurance company tax on the investment.
- There will be no further tax on UK dividend income whilst the investment accumulates within the fund for the investor’s benefit.
- The investor can switch between different investment funds within the bond with no tax charge at that time.
- If the investor requires access to the bond, he can make use of the 5% pa withdrawal facility. This means that he can draw up to 5% of the premium each year until he has withdrawn the total premium paid with no immediate tax charge. 5% pa allowances not used in one year can be carried forward to the next and so on.
- The bond can be effected on more than one life on a last survivor basis to give maximum control over the time it is encashed.
- On final encashment of the bond, profits will only be subject to tax if the investor is a higher rate taxpayer (or the top-sliced gain makes him a higher rate taxpayer). For a higher rate taxpayer the tax charge will be at a rate equal to the difference between higher rate tax and basic rate tax ie 20% (40% less 20%). An additional rate taxpayer will have a further 25% to pay. No liability arises for a basic rate taxpayer and so, if encashment of the bond is deferred, tax on encashment can be avoided on the investment.
The following example illustrates the benefits of investing in equity linked funds using an onshore Investment Bond.
John has an existing portfolio of investments which make full use of the dividend allowance of £1,000. He has £20,000 of new cash to invest. He is a higher rate taxpayer. He wants to invest for long-term asset-backed growth linked to equities. Using an assumption that he invests directly into equities which yield 4%, the net income available for reinvestment would be as follows:
|Tax at 33.75%
|Net income (a)-(b)
Using the same assumptions, if he invests via an Investment Bond which invests in equities this would produce a dividend of £800. If this was all franked UK investment income it may not be charged to tax within the insurance company. Over the medium to long term this would produce significantly increased investment returns. Moreover, provided John ultimately encashed the bond when only a basic rate taxpayer, no further tax liability would arise.
In the meantime if John required access to his investment this could be achieved without any immediate tax by using the 5% pa withdrawal facility.
Planning on Final Encashment
For those higher rate taxpaying investors who have taken 5% pa withdrawals and then wish to encash their policies with the minimum of tax, consideration could be given to assigning their policy unconditionally to their spouse if he/she is not a higher rate taxpayer. No tax would arise on the assignment. On subsequent encashment, if after the addition of the top-sliced gain, the spouse is still a basic rate taxpayer, no tax charge would occur. There must be no agreement that the proceeds will be returned to the spouse who originally owned the policy.
Sheltering from 40% tax for higher rate taxpayers
For investors who are higher rate taxpayers on final encashment they can comfort themselves in the knowledge that the actual rate of tax suffered on the bond growth would still be less than 40%. Consider the following example:
Stan is a higher rate taxpayer. He invests £20,000 in to an investment bond. Investment growth and accumulated income within the bond, before taxation, is £10,000. After 20% “internal tax” the value of Stan’s bond has increased by £8,000. This net value is reflected in the value of the bond and, after 5 years, when the bond is worth £28,000, Stan encashes it. His chargeable gain is £8,000 and he will suffer 20% higher rate income tax on the gain which amounts to £1,600. This means his after-tax profit is £6,400 on an overall gross profit of £10,000. Despite the fact that he is a 40% higher rate taxpayer Stan’s investment growth has only suffered tax at 36%.
As illustrated the onshore investment bond can be a very efficient tax wrapper for reinvested dividend income for investors who already have dividend income in excess of £1,000 each year. However, it’s not all about “the numbers”. There are other important factors that can influence the most appropriate wrapper choice.
Factors such as:
- The regular use of the CGT exemption, although this reduced from £12,300 in 2022/23 to £6,000 in 2023/24 and will reduce further to £3,000 in 2024/25.
- Encashment strategies for both bonds and collectives, possibly involving assignment (by way of gift) which is always tax free with a bond regardless of the relationship between assignor and assignee.
- Administrative simplicity, again this usually favours the bond.
- Investment switching has no tax consequences under a bond.
- The fact that on death of the holder of a collective its cost value will be re-based to that at the date of death so that all accrued gains to that point will be “wiped” out.
- The impact of charges under the competing products.
- In some cases it may be that the desired underlying investment is only available through one or a restricted number of investment wrappers.
In summary, tax, charges and choice of the underlying investment together will influence the choice on financial grounds. Where “non-financial” benefits like administrative simplicity or ease of holding in trust are delivered by a product that does not provide the optimum financial return the difference in financial return will represent the “price” for these benefits and the investor will have a clear cost/benefit decision to make.
This information has not been approved for use with customers and is based on Aviva’s interpretation of current law and legislation, and our understanding of HM Revenue & Customs (HMRC) practice as at 24 October 2024. It is provided for general information purposes only and should not be relied upon in place of legal or other professional advice. Both the law and HMRC practice will change from time to time and our interpretation may be subject to challenge by HMRC or other regulatory body. Aviva cannot act as legal adviser for you or your clients. You should always seek appropriate legal or other professional advice.