The ‘perceived wisdom’ of tax planning is often to use your pension and Isa allowance first then make use of your CGT allowances. Arguably, efficient tax planning should be and always has been about getting the right balance of bonds and OEICs as both have a place depending on the client’s circumstances.
The benefit of using the AEA is that you can achieve gains on your capital without incurring any CGT. As the higher rate of CGT for investment gains is 20 per cent, when it was set at £12,300, the exemption saved up to £2,460.
In the past, for some clients it may not have been worth giving up this CGT-free amount as the CGT saved more than made up for additional tax payable on their dividends and income each year.
Now that the AEA has been lowered to £3,000 and the maximum CGT savings for higher and additional rate taxpayers is £600, the dial has shifted in favour of bonds.
The key question now, when considering a GIA over a bond, is whether an up to £600 reduction in your CGT bill is worth the additional tax that may be payable on your investment income.
For many people the corporation tax journey inside a bond will be more tax efficient than the personal tax journey outside a bond in a GIA. And the more income-driven the individual’s returns are, the more tax efficient a bond becomes.
In practice, where a fund’s return includes dividends, the tax payable will be lower than 20 per cent. As an example, the average rate of tax in Prudential’s With-Profits Fund, which powers its smoothed products, has averaged 14-15 per cent over the past 20 years or so.
Even though the corporation tax bill will likely be less than 20 per cent, the individual gets a 20 per cent income tax credit.
Taxation on encashment
So far, we have looked at what happens over the investment term inside the bond, but to get an overall picture of the total tax payable we need to assess how much tax will be paid when the bond is encashed.
This will be between 0 per cent and 25 per cent depending on the availability of top slicing relief.
Top slicing relief can be complicated to calculate but the principle is fairly straightforward and some bond providers have tools to help advisers and paraplanners do the analysis.
Top slicing relief is designed to give relief from having a gain built up over several years that is all taxed in the same tax year.
Instead it tries to assess the tax as if you had received the average annual gain (knows as the slice) each tax year.
