liability to excess income tax as bond encashment rises from 18% to 20% from 2004
The 5% tax deferral rule on investment bonds will become more attractive to higher rate tax payers as they face an additional 2% income tax on chargeable gains from 6 April 2004.
With effect from 1 April 2003, corporation tax paid within life funds has fallen to a flat rate of 20%.
Previously life funds bore this tax at an overall rate of 22% and in non-qualifying policies, such as investment bonds, basic-rate tax payers had no further income or capital gains tax liability on investment gains.
However, higher-rate tax payers faced an excess income tax charge of 18%, which is the 40% rate minus the 22% covered within the fund. This translates into a 22% tax credit for higher rate tax payers.
In last week's Budget the Government reduced the tax paid within life funds to 20% and from 6 April 2004, will reduce the tax credit for higher rate tax payers to 20%.
This will effectively increase their income tax liability on chargeable gains by 2%. Although the drop in the tax credit only starts from 6 April 2004 it will apply to the full term of the policy. This means if a higher rate tax payer has held a bond for 19 years and surrenders after 6 April 2004 then they will face the extra 2% taxation on the gain for the whole term of the investment.
Paul Thompson, technical support manager at Scottish Widows, said if investment bondholders want to avoid paying this extra income tax on gains they can surrender their policy prior to 5 April next year and still get the 22% tax credit.
Otherwise, bondholders can continue making use of the 5% withdrawal capacity, not withdrawn in the Budget despite industry fears it might be.
Under the 5% rule, investors can withdraw that amount of the original investment each year for a maximum of 20 years without immediate liability to income tax.
Higher-rate tax payers have used this feature to defer encashment of investment bonds until their taxable income falls to that of a basic rate tax payer as a result of retirement or a low income year in order to reduce or avoid the excess income tax payment on the chargeable gain.
However, if the policy has a specific maturity date, although extremely rare on investment bonds, the Revenue has moved to close a loophole in the use of the 5% tax-deferral rule.
Holders of life insurance policies have previously been able to exercise an option to re-invest the proceeds of a maturing policy into a new policy with the same insurer, without the gain on maturity being immediately taxable.
Some policyholders have used this rule in conjunction with the 5% rule to defer tax on the gain at maturity of the first policy.
The Revenue's proposed revision means a policyholder may never use the 5% tax deferral rule to withdraw more than the original premium without a tax charge.
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