1. The different tax wrappers available
2. What to be aware of when it comes to capital gains tax
3. How bonds fit into the tax wrapper definition
Understanding tax wrappers, allowances and trust planning is important to make sure you are making the right use of your money.
In this Akademia module with Paul Fidell, head of business development in investments, Prudential we will summarise the various investment wrappers such as Pensions, ISAs, OEICs and bonds and go on to discuss trust planning and how bonds – both onshore and offshore fit into this. So let’s take a closer look at what we are going to be covering over the course of this module.
- Well, we start with looking at the different kinds of tax wrappers available
- We will then take a closer look at tax allowances
- How tax allowances interact with tax wrappers
- How onshore bonds works as a tax wrapper and how tax efficient are they
- We will also touch on offshore bonds to look at the taxation situation there
- We will then move on to how bonds fit into trust planning
- We will look at inheritance tax implications
- We will explain how tax deferral works and top slicing
- And will look at investment bonds, what they are and why they are still relevant
But first my colleague Mark Colgate asked Paul how tax efficient are the tax wrappers and structures
PAUL FIDELL: Well that’s actually quite a big question, because there are many different tax wrappers. I guess if we’re thinking about the four major ones, the big building blocks if you like, I guess we’d be talking about ISAs, we’d be talking about pensions, we’d be talking about bonds, both onshore and offshore bonds, and then OEICs or authorised investment funds. Alongside that you’ve obviously got a whole range of others VCTs, EISs and so on and so forth. But those four I guess will be the major building blocks that an adviser might look to use.
PRESENTER: Well let’s talk through those four major ones. So IASs first of all, are these becoming more important, particularly as we get changes round pensions?
PAUL FIDELL: Yes I think so. I mean they’re obviously a bit favourite of the government. There’s lots of encouragement being given to people to make use of ISAs. I mean what’s really interesting is if you actually look at how they’ve been used in the past, and the government’s own statistics, they produce these at the end of each tax year. And the latest set going back to end of April 2016, there’s about £½trn sitting in these things. But that’s split roughly 50/50 between stocks
and shares and cash.
Now, I’m certainly not in the camp of thinking that a cash ISA is a waste of a tax wrapper because you’ve established the discipline of having one and putting money into it. But certainly with rates, interest rates as they are at the moment, you could argue from a gains perspective. You’re not making the most of the tax wrapper. But yes, about 50%, and the vast majority of flows are into the cash versions of these, which arguably isn’t the greatest use of your cash.
PRESENTER: And then there’s OEICs, unit trusts. Some people might be surprised to see them there as we think, we don’t tend to think of them as a tax efficient wrapper.
PAUL FIDELL: No, that’s right, and I mean a lot of OEICs will be bought through some form of tax wrapper. So whether that’s something as straightforward as a platform, or through an ISA or a pension or a bond, but there are still quite a lot of money going into unwrapped OEICs, and they are indeed a tax wrapper. And there will be situations where they are a favoured tax wrapper.
PRESENTER: Pensions next, are they becoming less important as we’re seeing all of these limits being put on how much you can put in them, how much you can build up in total?
PAUL FIDELL: I don’t know about less important, I mean I think they will always be important. I mean the obvious advantage you have is you’ve got tax relief on the contributions that you’re make into a lot of pensions. And you’ve obviously got the freedoms that were introduced a couple of years back. I think the challenge is certainly when you start to use them in a decumulation world. So the old idea of the pension was that you’re building up a fund of money, and you’re going to start to draw down on that money. I think at that point you’ve got to then question is it necessarily the first point that you would go to for your retirement income, or are there better more tax efficient opportunities. But certainly they will still have a place, and I guess your favoured ones would be ISA and pension first, and then start backfilling everything else.
PRESENTER: And then finally bonds, onshore and offshore, we hear a lot less about bonds these days.
PAUL FIDELL: We do, and I think there’s an element of, it’s a bit unfair actually. I think they’ve sort of, more than any other product they’ve probably been labelled
with that pre-RDR world, and labelled as a high commission earning product, part of the bad old world if you like. And I think that’s a bit unfair. I mean the product structures have developed dramatically since our day. We’re now longer talking about high up front allocations and large back end penalties. These tend to be clean in clean out contracts now suitable for an adviser charging model. But they almost, it’s not baby out with bathwater but they do seem to have been unfairly labelled and people have favoured other things. Which I think is doing them a little bit of a disservice. I think they have a part to play as part of an overall planning process with any client looking to make the most of their tax efficiencies.
PRESENTER: Those are the wrappers. Let’s move on to some of the tax allowances as well. What do we need to be thinking about here?
PAUL FIDELL: Well there’s a definite order in terms of taxation, and everything has its place in the ladder if you like. I mean the starting point for everybody would be earned income, pension income, which would obviously count against your personal allowance. So the personal allowance that everybody gets, the £11,500, that’s your start point. And then we start to build on other forms of income on top of that. The next one in the ladder would be savings income. So you’ve got a couple of allowances here that you can make use of. There’s £1,000 personal savings allowance which everybody gets. Obviously if you’re a high rate taxpayer or additional rate taxpayer that reduces, so £1,000 standard, reduces to £500 and then zero if you’re an additional rate taxpayer. But there’s also a £5,000 savings allowance.
Now, that’s not necessarily available to all, and it’s determined by how much income you’ve effectively got. That £5,000 is potentially quite useful, because that gives you quite a lot of scope to have investments that generate savings income, and to offset it against that allowance. Moving up from there we could then look at dividend income, and there was a bit of a shock to the system a while ago when the government introduced a £5,000 dividend allowance. So we moved from a situation where I think people generally understood that dividends up to basic rate tax thresholds you didn’t have anything extra to pay. There was a tax credit system, and that met your basic rate liability. And then suddenly we moved into this world where ah that’s not the case anymore, you’ve got £5,000 and that won’t attract any tax. But beyond that 7½, 32½ and 38.1 were the rates of tax. Then of course just before the general election we had the Conservatives talking about reducing that again to £2,000. Those plans got shelved of course, but they’re probably going to reintroduce that.
So we’re looking at not a lot of dividend income if you’ve used up all of that allowance. And then when we move on from there, now whilst not technically income capital gains, and everybody has an £11,300 allowance. So you could generate regular payments which could look like income by way of encashment of gains. And then on top of that there’s a whole range of other things you can do. Pension commencement lump sums for example, ISAs where you’re extracting income from an ISA, the 5% tax deferred allowance from insurance bonds. All of those would sit on top of this tax stack. And the key point is that that order is defined for you, and in many cases the adviser’s job would be to work out where best to put a client’s investments to make maximum use of the allowances that are available.
PRESENTER: Well that’s the background of the tax allowances. Perhaps we could turn now to how those allowances interact with some of these wrappers we’ve been talking about. So if we started with ISAs taxation, what are the key takeaways here?
PAUL FIDELL: Well that’s certainly the easiest one, because we can effectively say, I mean if you take the three strands of return that you could get. So if we talk about capital gains, we talk about dividends and we talk about savings income, which could include interest. Then effectively in an ISA wrapper those three strands of return are tax exempt in the hands of the ISA provider, and of course tax exempt in the hands of the ISA holder. So that’s an easy one, straight through all of them are exempt, which makes them very attractive.
PRESENTER: And then what about bonds, because we touched on that earlier, many people don’t think of them naturally as a tax wrapper in their own right?
PAUL FIDELL: Yes, authorised investment funds, collectives, there’s a slight difference in terms of the tax treatment. The major one is I guess in terms of capital gains. We’re now talking about an investment which is going to be subject to capital gains. Now that does of course mean you can make use of your £11,300 allowance, whatever’s available to you, so that’s good news and there will be circumstances where people want to make use of that allowance. So you would naturally be inclined towards using a collective. In terms of dividends then in the hands of the fund manager they’re exempt. In the hands of the individual investor, and we’re assuming these are unwrapped now, they’re not part of an ISA or any other vehicle. In the hands of the investor you can obviously make use of the £5,000 dividend allowance, and then the progressive rates of tax thereafter. And then in terms of savings income, this is where we’ve had a change recently.
PRESENTER: And in this move from if you like the grandparent through the trustee to the children, does that count as a potentially exempt transfer, do you have to, does the grandparent have to live a certain amount of time?
PAUL FIDELL: Yes, I mean if you’re talking about people moving money into a trust, then of course there is the IHT implication. Once the money’s actually in the trust, so if we’re talking about the investment being made by the trustees themselves, so they’ve got a pool of money they’re responsible for, they’re making the investment, they’re making it essentially on behalf of the beneficiaries, then there is no IHT implication within that because the trust has already been established. And that’s where these things come into their own in terms of tax efficiency.
PRESENTER: And we’ve talked about a number of wrappers and all of these tax situations, is there a hierarchy in terms of which advisers should look to use up allowances ISA first then pension, any rules or does it really depend upon individual circumstances?
PAUL FIDELL: The obvious rule that comes from the order of taxation, which is trying to make use of those allowances because they do stack in a certain way, so making sure that you’re using your investments in the right way. I guess where it particularly comes in is in an accumulation environment where I’m building up money for the future, then essentially I’m not really too concerned about the tax treatment on encashment, because I’m still at a point where I’m building things up. When we move into a decumulation situation, and you’re starting to think okay I need to replace income, so how am I going to do that, which tax wrappers am I going to use? Then there is very definitely an order. And I guess in the old world with pensions where you were essentially compelled to buy an annuity, that was your first point of call for retirement income, and then you filled in with other things.
Now I guess there’s an argument to say actually that’s the last thing you want to touch, a pension. The first thing you want to touch is an ISA, because of course you can now extract money from an ISA. Well you’ve always been able to do this, but you can extract money without paying any tax at all. So if you’ve got a pot of ISA money, and you’ve got a pot of pension money, and you’ve got a pot of some other stuff, use your ISA first and then start to think about pension, but maybe there’s another one you can bring ahead of it and almost your pension becomes the last thing you touch. Because of course the income that you generate from it
is going to be fully taxable. So you could use an ISA, you could use the 5% tax deferred allowances from a bond, and then you could use a pension. And again it’s that point about making all of these things work in conjunction with each other.
PRESENTER: Now going back to investment bonds, just talk through in a little bit more detail how the tax deferral works and how top slicing works.
PAUL FIDELL: Yes, top slicing is one that always catches people out. I mean the taxation, basically you have a situation which is called a chargeable event. A chargeable event, death of all the lives assured, full encashment or a partial encashment which exceeds the 5%. Now the 5% people know about is a taxed deferred allowance, essentially it runs for 20 years. And the idea is that 20 times five is 100%. That’s your capital bag, and anything extra is a gain and therefore taxable. So if you exceed, well if you have a death of all the lives assured, if you have a full encashment or you exceed the 5% then you trigger what’s known as a chargeable event. And that prompts this calculation of a gain. Now the insurance company will do this for you. They’ll actually tell you what the gain is, but they then leave you to deal with what to do with that gap. And the top slicing rule basically is a recognition by HMRC that it would be a bit unfair, and obviously it goes back to their predecessor the Inland Revenue.
It would be a bit unfair to take the whole of a gain that you make. So let’s illustrate it by an example. Let’s assume you took out an insurance bond five years ago for £100,000 and it’s now worth £150,000. You cash the whole thing in, on the face of it you’ve got a gain of £50,000. What they recognise it would probably be a bit unfair to dump the whole of that £50,000 onto your income at that point in time and say well I’m sorry tough, you’re now a high rate taxpayer and you’ve got to pay 40% tax on it. So what top slicing allows you to do is to say what’s the average gain? So you take the gain that you’ve made, but you divide it by the number of years that you’d held the policy.
PRESENTER: So we have a £50,000 gain over five years.
PAUL FIDELL: Over five years, that would be £10,000, and you add the £10,000 to your income. Now if that doesn’t push you over the threshold between basic and high rate tax, then you don’t have any further tax to pay. Within an onshore bond the tax that’s been deducted at source will be deemed to be the equivalent of basic rate tax, so effectively job done. If you fall over the limit, and half your gain is over and half your gain is under, you’ll only pay excess tax which would be your marginal rate, so 40%, minus the assumed rate of 20%, you need only pay
it on that bit that’s over the base rate threshold. So it’s a way of I guess protecting policyholders from an unusually large gain affecting their tax position.
PRESENTER: So how tax efficient might an onshore bond be for a higher rate taxpayer? Because I can see if you’re a basic rate taxpayer no more to pay, that’s pretty easy.
PAUL FIDELL: The big advantage of bonds comes down to a work which is control, and it’s around control of the timing of the tax liability. Where they have the greatest degree of efficiency is where the expectation is that somebody is at a higher rate of tax now, and will be at a lower rate at some point in the future, i.e. at the point when you’re going to make the encashments. So somebody who’s a high rate taxpayer now that ability to shelter the tax that will be paid otherwise if they invested directly through into a collective. You’re effectively deferring that tax, and you’re deferring it to a point when they’re actually going to pay less tax anyway. If somebody is for example going to be a base rate taxpayer throughout, both through the lifetime and on encashment, then you need to do the calculations. And there are lots of calculators which will do comparisons between insurance bonds, both onshore and offshore, and collectives for different scenarios.
I’m a high rate taxpayer now, I’m a high rate taxpayer when I’m taking the money. I’m base rate, base rate, higher rate, reducing to base rate, all these different combinations, and they’ll crunch the numbers for you, and it is simply a numbers game. The one area where you would not want to use an onshore bond is if you have a non-taxpayer. Because essentially what you’ll be doing is putting somebody who’s not suffering tax into a vehicle which suffers tax at source, which is non-reclaimable. So that’s a no-no, non-taxpayers should not go into onshore bonds. Whether they should go into offshore bonds that’s another question, because with an offshore bond, and this is one of the quirks of the system. In that tax stack the savings income, the £5,000, bizarrely offshore bonds are treated as savings income.
So gains from an offshore bond could be offset against the £5,000. They can’t if they’re an onshore bond gain. Nobody really knows why that’s the case but it just is. So with an offshore bond for a non-taxpayer who wants to use their £5,000 savings allowance, then that makes a lot of sense, but a definite no-no for an onshore bond.
PRESENTER: Well lots to think about there. In the last five minutes of the
programme could you run us through some situations, specific situations where on and offshore bonds can make sense, just some scenarios?
PAUL FIDELL: Yes, I mean there’s one I’ve mentioned already. So the non-taxpayer who’s looking to make use of their non, their savings allowance of £5,000 then an offshore bond would make a great deal of sense. We do see situations where somebody anticipates that they’re not going to be in the UK, they’re going to be a non-UK taxpayer at some point in the future. So the deferred ex-pat if you like. And government studies when they’ve done things like looking at future liabilities from social security have identified quite high percentages of the population who have an ambition I guess to actually not be here in retirement, the lure of the sunnier climes and so on and so forth. Now how many of those in reality move is a big question, but if I’m in that situation and I’m looking to put plans in place today that will serve me well in the future when I’m not in the UK tax system, then the opportunity of deferring all my taxes through the use of an offshore bond for example actually has quite a lot of appeal.
Other areas where we see them being used. We’ve historically done lots of business as an industry in the area of SIPPs and SASSs where people have used offshore bonds as essentially a trustee investment vehicle within a pre-pension scheme. And that’s been to give you access to different funds which you couldn’t otherwise buy. Now that situation has changed slightly I guess over the years as pension structures have become much more open architecture and given you access to those investments. But there are still some esoteric investments which suit certain individuals, and you can buy those through an offshore bond that you’re writing within a pension scheme. So I mean there’s three or four.
The other one I guess we’ve already referred to, that assignment situation. And back to that situation with grandparents and grandchildren, grandparents perhaps looking to do educational funding for their grandchildren. Now grey situation where you could use a bond and a trust. That gives you the control aspect, gives you deferral of tax. And what you’re doing is you have to wait until the child is 18, because the assignment has to be to an adult, but once they hit 18 and perhaps going into tertiary education, university and such like, then rather than just allowing them free rein to have the cash, why not assign individual policy segments to them? They encash them, they’re almost guaranteed to be a non-taxpayer, most students don’t actually have enough taxable income to push them over the allowances; in which case you’ve got a very tax efficient source of income for the child, and very tax efficient for the grandparents as well.
PRESENTER: You mentioned retiring abroad there, do these vehicles, they sound very British sort of bonds, does that cause potentially some problems with overseas tax authorities?
PAUL FIDELL: Yes, I mean you have to be, whenever you’re planning with expatriates or those who are resident in a foreign country, you have to be very careful that you’re not creating a structure which is actually going to create an unfair tax position where they’re actually resident. There is quite a lot of help and assistance, the Association of International Life Officers for example have a website which has a number of tax guides on there covering a lot of the major countries where ex patriates go. But yeah, it’s certainly an area you need to be mindful of. There are many areas where actually there is no defined mechanism for the taxation of insurance products. Others will have a specified rate of tax that they’re going to apply to these. The key thing is take advice, which of course is where the financial adviser comes in. I wouldn’t ever encourage an individual to go into this without proper financial advice.
PRESENTER: Final question, we hear so much about ISAs and pensions these days, very little about investment bonds in the grand scheme of things. If you’re an adviser what’s the best way of explaining what they are and why they’re still relevant to our client base?
PAUL FIDELL: I think to describe them as a tax wrapper. I think that bit’s been forgotten about. I think they are labelled as a product, whereas everything else seems to be labelled as a tax wrapper. So I think first thing is let’s stop referring to them as a product. Let’s refer to them as what they actually are, which is a tax wrapper which can be used in a variety of circumstances. I’m not for one minute suggesting that these are universal panacea, the answer to everybody’s problems. They’re not. What they are is another string to your bow, and I appreciate I’m mixing lots of metaphors up here but they are another string to your bow that you can use in certain circumstances. And if they’re not right don’t use them.
I mean the classic one would be somebody who wants to make use of their capital gains tax allowance. Insurance bonds don’t suffer capital gains tax. So you wouldn’t ever use it. There are better vehicles to use. But understanding where you can use them, and using them with other tax wrappers to maximise the situation for the client, that feels like (a) a good thing and (b) something that an adviser should be doing as part of the whole financial planning process. To disregard them as an old school product, and leave them out of the mix just feels you may be doing yourself a little bit of an injustice.
PRESENTER: Well lots to think about there. We are out of time. Paul Fidell, thank you.
PAUL FIDELL: Thank you.
In order to consider the viewing of this video as structured learning you must complete the reflective statement to demonstrate what you have learned and its relevance to you.
By the end of this session you will be able to understand and describe:
The different tax wrappers available
What to be aware of when it comes to capital gains tax
And how bonds fit into the tax wrapper definition
Please complete the reflective statement to validate your CPD