Insurance gain? – reduce tax by making a simple pension contribution

The issue

When insurance bonds are redeemed a relief known as ‘top-slicing’ may be available in order to limit the tax liability. This is relevant when an insurance bond gain would otherwise push a taxpayer into a higher rates of income tax.

For example, an individual may pay tax at the basic rate of 20% ignoring bond gains but the gain could push him into the higher rates of tax. Without ‘top-slicing’ the majority of the gain would be taxed at 40% or even 45%

‘Top-slicing’ allows the gain arising to be divided by the complete number of years that have run on the bond. This divided gain is then treated as if it arose in the year of redemption and the additional tax at 20% or 25% on this element is calculated. This hypothetical tax is then multiplied out by the number of years the bond and becomes the actual tax payable on the gain (assuming it is a UK bond).

 

Example

Roger redeems an onshore bond which he has held for over 10 years resulting in a gain of £100,000. Ignoring the bond gain he would have £5,000 of basic rate tax band remaining, meaning £95,000 of the gain will be subject to an additional 20% tax charge over and above the basic rate tax deemed to have been paid within the bond itself.

Top slicing relief involves dividing the £100,000 gain by the 10 complete years of ownership (giving £10,000) and then checking how the rates apply to that amount. In this example £5,000 of the £10,000 would be subject to an additional 20% tax liability. This annual tax charge is then multiplied out by the number of years (10) to give the actual liability with top slicing. In this example top slicing reduces the tax by £9,000.

 

How pension contributions can further reduce the tax

The position in the above example can be improved by extending the basic rate band.

If for example Roger were to make a personal pension contribution of £4,000 (£5,000 gross) then his basic rate band would be increased by £5,000. This would have the effect of moving all the bond gain out of the 40% band. Therefore in this example a further £10,000 of tax can be saved by paying £4,000 into a pension fund (which is also tax efficient in its own right!)

It should be remembered that top slicing relief is a hypothetical calculation and does not impact upon other reliefs, such as the personal allowance. The personal allowance will be withdrawn completely in both examples above due to the high level of income (£128,500 in total). However in this example as all the tax is payable at basic rate it would not be worth increasing the pension contribution.

 

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