Several fund managers market income drawdown schemes within their fund ranges. If you are a UK taxpa...
Several fund managers market income drawdown schemes within their fund ranges. If you are a UK taxpayer, these can look very tax-efficient. UK authorised unit trusts and Oeics, as well as offshore funds with distributor status, are subject to a very favourable tax regime in relation to capital gains. Firstly, within the fund itself, the fund manager can deal in the underlying shares on a regular basis without incurring capital gains tax liabilities (CGT), so the fund acts like a gross roll up vehicle in relation to capital gains.
On encashment of units, the gains on UK authorised and offshore distributor funds will be subject to CGT. This is a favourable tax regime as taxable gains will be reduced by taper relief after three years, and every year after so that, by year 10, only 60% of each gain will be taxable. After taper relief, the investor can also deduct their annual CGT allowance from the gain. This is currently worth £7,900, and usually rises each year in line with inflation.
So, it is this favourable CGT regime that income drawdown schemes take advantage of. 'Income drawdown" is a misnomer, as you are in fact withdrawing capital by way of partial encashment of units. When units are partially encashed from a fund, the gain is worked out by deducting a capital element from the payment.
The capital element is worked out by a formula: I x A / A+B, where 'I" is the initial investment, 'A" is the value of the withdrawal, and 'B" is the value of the remaining units after the encashment has been made. This capital element is deducted from the payment, and the remainder is the gain. Any available taper relief is then applied to reduce the gain and the annual exemption will reduce it further before tax is chargeable.
For example, if the initial investment is £250,000, and a withdrawal of 5% (£12,500) is taken at the end of year one, assuming net growth of 6%, the capital element would be worked out as follows:
250,000 x 12,500 = 11,792
12,500 + 252,500
Therefore the gain of (12,500 - 11,792) £708 is well within the annual exemption, so no tax is payable. The capital element from the previous withdrawal is deducted from the initial investment before the gain is worked out on subsequent withdrawals. So, if the same withdrawal were taken at the end of year two, the capital element would be worked out as follows:
(250,000 - 11,792) x 12,500 = 11,125
12,500 + 255,150
So, the gain of (12,500 - 11,125) £1,375 is again within the annual exemption and no tax is payable. If you roll this forward for, say, 10 years, assuming the annual exemption increases by 2.5%pa, the figures would look like this:
Year Value Withdrawal Capital Gain Tapered gain Allowance Tax
1 265,000 12,500 11,792 708 708 7,900 0
2 267,650 12,500 11,125 1,375 1,375 8,098 0
3 270,459 12,500 10,495 2,005 1,905 8,300 0
4 273,437 12,500 9,901 2,599 2,339 8,507 0
5 276,593 12,500 9,341 3,159 2,685 8,720 0
6 279,938 12,500 8,812 3,688 2,950 8,938 0
7 283,485 12,500 8,313 4,187 3,140 9,162 0
8 287,244 12,500 7,843 4,657 3,260 9,391 0
9 291,228 12,500 7,399 5,101 3,316 9,625 0
10 295,452 12,500 6,980 5,520 3,312 9,866 0
As can be seen, based on my assumptions, the investor will never pay tax on their income - this is true even if you roll this forward for 20 years. Therefore, an income drawdown plan using authorised or distributor funds is an excellent way to supplement income. This is very useful for higher rate taxpayers wishing to maximise UK tax breaks, or for retired individuals wishing to supplement pension income without affecting entitlement to age allowances.
However, this is only true as long as the assumptions remain consistent, which they rarely do, and to the extent that the returns are made up totally of capital gains, which they never are. Next month, I will look at some pitfalls with this strategy.
This article contains general information only and is not intended to be taken as specific investment or tax advice. It is based on the assumption that further information would be required and provides only a guide to some of the relevant routes an IFA could cover.
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