Technical Connection examines how to use personal pension contributions to reduce tax on chargeable event gains
When an individual encashes a single premium bond, any chargeable event gain that then arises can be subject to income tax at higher/additional rates if a UK bond, or higher/additional and basic rates if an offshore bond.
The inclusion of the chargeable event gain can, in some cases, also cause an increased tax on other income because of the loss of the personal allowance, reduction/loss of the personal savings allowance and an increased rate of tax on dividend income, but that is another story.
Where the top-sliced gain on the bond encashment causes the policyholder’s income to fall into higher rate or additional rate tax, a very effective planning strategy can be for that policyholder to, where permitted, make a personal pension contribution.
Geoffrey has earned income of £42,500, dividend income of £2,500 and savings interest of £1,000. He surrenders his UK investment bond, realising a chargeable event gain of £42,000. He has held the bond for seven years.
To calculate the tax liability on the bond, it is necessary to:
- Calculate the higher rate tax on the whole chargeable event gain.
- Calculate higher rate tax using top-slicing rules and determine any top-slicing relief.
- Then deduct any top-slicing relief from the higher rate tax on the whole chargeable event gain to determine the net tax on the chargeable event gain.
On this basis, the total tax liability on the whole chargeable event gain is £16,000. Having deducted the basic rate tax credit of £8,400, this means that the higher-rate tax liability on the whole gain is £7,600.
The top-sliced gain is £6,000. Total tax on this would be £1,600. After deduction of the basic rate tax credit of £1,200, the higher rate tax on the top-sliced gain is £400 so, multiplied by the top-slicing factor of seven, this comes to £2,800.
Top-slicing relief is therefore £4,800 (£7,600 less £2,800); and the total tax payable on the whole gain
But what if Geoffrey paid a personal pension contribution of £1,600?
Well, then his basic rate tax band would be increased by £2,000 – the grossed-up contribution. This would mean that all of the top-sliced gain would fall within Geoffrey’s increased basic rate tax band, meaning that no income tax arises. Top-slicing relief will therefore be £7,600, meaning that no tax will be payable on the chargeable event gain.
By following this strategy, not only will Geoffrey avoid tax on the chargeable event gain but he will have a highly tax-efficient investment in the shape of the pension plan. Geoffrey has achieved simple planning with a highly attractive outcome and still gets to keep £40,400 of the profits under his investment bond.