Bonds versus collectives for basic rate taxpayers

Summary

For additional, higher and basic rate taxpayers two of the most important determinants when choosing the most tax effective wrapper for a particular portfolio are

• the expected balance between income and capital gains and
• the personal tax rates/reliefs/exemptions/allowances applicable to the investor.

In this article, we focus on the importance of wrapper choice for basic rate tax payers, a very important segment of investors.  

Facts and analysis

Assuming that ISAs and pensions are always considered first, a common choice for retail investors with capital to invest is between investment bonds and collective investments, such as unit trusts and open-ended investment companies (OEICs). There are UK and offshore versions of both. Capital gains realised by investors from collectives (UK or reporting offshore collectives) are subject to CGT but capital gains realised by the investor when encashing an investment bond are subject to income tax.

Investments that allow the investor to access the CGT regime will also permit the use of the annual CGT exemption, which is £6,000 for the 2023/24 tax year. An investor will pay CGT at 10% for gains that, when added to their taxable income, fall below the higher rate tax threshold and 20% for gains that are in excess of the threshold (except for carried interest and gains on residential property which are taxed at 18% and 28%).

UK investment bonds, on the other hand, suffer a 20% internal tax on returns but, provided the “top-sliced gain” from the bond remains (when added to other taxable income) below the higher rate tax threshold there is no further tax paid on the gain by a basic rate taxpayer.

Offshore bonds suffer no direct “internal” tax (although they are likely to suffer withholding tax on source income) but the UK investor will be assessed on the returns with no tax credit. For the basic rate taxpayer this means paying 20% income tax on any gain.

It is absolutely essential to approach the choice of investment wrapper for a particular client with an open mind and commitment to making the decision that delivers the best outcome for the client taking account of all the factors, including (but not restricted to) fund and investor taxation.

Here are some of the key tax factors relevant for the UK basic rate taxpaying investor that can impact on the relative attraction of the investment bond and collectives.

Dividend Allowance and Personal Savings Allowance

The dividend allowance was reduced to £2,000 from the 2018/19 tax year and £1,000 from the 2023/24 tax year. The government has announced their intention to reduce the dividend allowance to £500 in 2024/25. This means that an investor won't have to pay tax of the first £1,000 of dividend income in 2023/24

The personal savings allowance means that a basic rate taxpayer can earn up to £1,000 each tax year in savings income tax-free (a higher rate taxpayer is able to earn up to £500).

If income from an investment is within the dividend and/or personal savings allowance the collective will generally be the better choice on tax grounds for the basic rate taxpayer.

Capital Gains

A key factor in analysing the complete tax position for a basic rate taxpaying investor is how the underlying investment growth arises. If it consists purely of capital growth and no, or little, income the collective will generally be the better choice on tax grounds for the basic rate taxpayer if the annual CGT exemption is available. For couples, of course, there would be the ability to effectively double the use of the annual exemption for a “combined” investment. 

Reinvested Income

While capital gains look tax attractive, at a time of highly volatile asset values many investors may consider capital growth oriented investments to carry a higher (and potentially unacceptable) degree of risk. It is widely accepted that having yield/income in a portfolio that is reinvested reduces overall risk and, over the long run, is an important driver of growth. To the extent that there is income in the portfolio, the basic rate taxpaying investor needs to consider the following:

• Franked UK dividend income paid to a UK insurance company suffers no additional tax and can thus be fully reinvested.
• Dividend income paid to a collective will, after deduction of management expenses, generally be taxed on the investor – even if accumulated. A basic rate taxpayer will have no further liability on dividend income if it falls within their dividend allowance.  If dividends are in excess of their allowance however, a basic rate taxpayer will be liable to tax at 8.75%
• In the current volatile investment markets, money/cash funds continue to have an appeal. Here, interest paid to a UK life fund will be reinvested after 20% tax at life fund rates. Interest distributions received by basic rate taxpaying collective investors will suffer 20% tax year on year. The difference is that interest payments within the available personal savings allowance can be reclaimed by a collective investor but not a UK life fund investor.  Interest accumulating in an offshore bond will suffer no tax within the life funds (although withholding tax may have been suffered at source) and consequently there will be no tax credit for the investor when an encashment takes place and a gain is made. The basic rate taxpayer would thus have a “latent” 20% liability possibly higher if the gain is realised in a year where the gain (or part of it) falls above the higher rate threshold after top-slicing relief.  The personal savings allowance can be used by an investor when calculating any tax due.

As a rule of thumb, therefore, all other things being equal (including respective charges) for capital growth driven by capital gains a collective looks “tax best” for a basic rate taxpayer, especially if the annual exemption is available. For reinvested income where the investor has available dividend and/or personal savings allowance available the collective again looks 'tax best'.

Next steps

There are a number of factors to take into account when comparing collectives and investment bonds for basic rate tax payers so ‘one size’ definitely ‘doesn’t fit all’. The bigger the investment, and the higher the likelihood that the investor will exceed the dividend allowance and personal savings allowance, the greater the margin of difference in net returns under the wrapper available are likely to be. It is true to say, though, that the portfolio determined margins of difference are likely to be smaller for basic rate taxpaying investors that for higher or additional rate taxpayers.

And before closing it is essential to say that 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 and the cost of advice to effectively use the annual CGT exemption.
• encashment strategies for bonds and collectives – possibly involving assignment.
• administrative simplicity – again this favours the bond.
• investment switching – with no tax consequences under a bond.
• estate planning.
• the fact that on the 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 unrealised gains to that point will be “wiped” out and
• the impact of product charges.
• 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 underlying investment together will influence the choice of wrapper on financial grounds. We have deliberately given greatest attention to tax in this article.

Where value is attributed to a non-financial benefit, like administrative simplicity or ease of holding in trust, then if the product that delivers the benefit also provides the best financial return based on the assumptions made – all well and good. Where these “non-financial” benefits are delivered by a product that does not seem to provide the optimum financial return the difference in expected financial return will represent the “price” for these benefits and the investor will have a clear “cost/benefit” decision to make.

Important information

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 6 April 2023. 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.