Onshore bonds

Investment bonds allow tax deferred withdrawals of up to 5% a year, after which a chargeable event occurs. When a chargeable event does happen, the deemed gain becomes taxable within that tax year.

For onshore bonds, the general rule is that an individual or trustee is treated as having already paid tax at the basic rate (20%) on the amount of the gain.

This means basic rate taxpayers have no further tax to pay. Higher rate (40%) taxpayers need to pay a further 20% and additional rate (45%) taxpayers 25% - Unfortunately, non-taxpayers are unable to reclaim the 20% notional tax.

Top slicing relief

As an investment gain will often have been generated over many years, it would be unfair to add the whole gain as taxable income in the tax year the gain is realised. Top-slicing relief is therefore available.

Top-slicing reduces the impact of the tax charge by looking to tax a gain that was built up over several years at the rate applicable to a single year’s worth of growth.

Where a chargeable gain results in a tax liability, making pension contributions can significantly reduce the tax burden. In some scenarios, the tax saving can be considerable.

Example - Naomi

Naomi earns £45,000 a year and has recently cashed in an onshore bond she has held for 25 years, resulting in a chargeable gain of £250,000. After discussing this with her financial adviser, she is advised to make a pension contribution of £4,000 net (£5,000 gross).

Let’s compare Naomi’s tax position before and after making the pension contribution…

For income tax purposes, Naomi’s total income (including the bond gain) is now well above £100,000. She therefore loses all her personal allowance (eroded by £1 for every £2 of income above £100,000). Her earnings after tax, depending on whether or not she makes the contribution would be as follows:

* Basic rate band is stretched by £5,000 (amount of gross pension contribution) to provide higher rate tax relief

This shows that the pension contribution has reduced Naomi’s net income by £3,000. Next, we need to calculate the tax liability on the £250,000 gain on the bond, after top slicing.

Step 1 – Calculate the tax due on the full gain:

In step 1, making the £5,000 pension contribution has meant that there is an additional £5,000 of higher rate tax available for the bond gain, reducing the tax liability by £250. 

Step 2 – calculate total liability for the year:

In step 2, basic rate tax at 20% is treated as already paid on the £250,000 gain within the bond. This is deducted from the tax liability.

Step 3 – calculate the annual equivalent (the top slice):

£250,000 (gain) / 25 (years held) = £10,000

Step 4 – find the total relieved liability using the top slice:

* Naomi’s earnings when added to the top-slice of £10,000 do not exceed £100,000. This means that the personal allowance is restored for the purposes of calculating the notional tax on the top-sliced gain. 

** Naomi’s earnings when added to the top-slice of £10,000 do not exceed £125,140 (the additional rate threshold). This means that £500 of the personal savings allowance is restored for the purposes of calculating the notional tax on the top-sliced gain.

To calculate the total relieved liability, we multiply the relieved liability by the number of years the bond was held:

Without the contribution: £846 x 25 = £21,150

With the contribution: £0 x 25 = £0

Step 5 – calculate top-slicing relief due:

Top slicing relief is the difference between the total liability and the total relieved liability

Without the contribution: £58,493 - £21,150 = £37,343

With the contribution: £58,243 - £0 = £58,243

The tax due on the bond is therefore as follows:

Overall, the £5,000 pension contribution has reduced Naomi’s earnings by £3,000. However, by making the pension contribution, she has fully eliminated £21,150 of tax due on the bond.

This means Naomi has £18,150 more in her pocket and an additional £5,000 in her pension, making her £23,150 better off overall. She has effectively received tax relief at an astounding rate of 463%.

Comment

The above example shows how sometimes it can pay to make a pension contribution. Where someone with a maturing investment bond has a chargeable event gain, it is always worth checking if there is scope to mitigate any tax impact through a pension contribution.

Important information

Please note this is for general information only and is based on LV's understanding of the relevant legislation and regulations and may be subject to change.

The tax treatment of benefits depends on individual circumstances, and may be subject to change in the future.

The use of this document is at your own risk, and the content should not be used for the provision of professional advice.

LV= accept no liability for any damages, losses or causes of action of any nature arising from your use of this document.