New Capital Gains Tax (CGT) rules have led some commentators to suggest that bonds are dead in the water. Stephen Hamp goes through what the changes really mean for investors and advisers?
The key changes heralded by new capital gains tax (CGT) rules revolve around the removal of the 'taper relief' and indexation allowance, and the implementation of a single rate of CGT of 18% for collective investment.
Before 6 April 2008 a higher rate tax payer holding a collective investment would pay tax at 40% on any realised gains over the annual exemption. However, they could benefit from 'taper relief', depending on how long they had held the asset.
This ranged from a 0% reduction for less than three years to a 40% reduction for ten or more years. This meant that higher rate tax payers holding their investment for ten years or more would only have to pay an effective tax rate of 24%. Basic rate tax payers would only have to pay an effective rate of 12%.
Clearly there was a certain level of complexity in this regime, which is why the Chancellor stated that simplification was one of the key drivers in his decision to abolish both taper relief and indexation relief.
The removal of 'taper and indexation relief' post 6 April and the introduction of the flat rate off 18% after the annual exemption means higher rate taxpayers could be better of investing in a collective, rather than an investment bond from a tax perspective.
That's because instead of having to pay an effective rate of 24% tax on an asset held for ten years, they will now only pay 18% on realised gains above the annual exemption.
In contrast, basic rate tax payers who held their investment for ten years or more could be worse off since before 6 April they would have paid an effective rate of 12%. Whereas the new flat rate of 18% could mean a 50% increase in their tax bill!
While upon initial inspection the new regime may appear to favour collectives for higher rate tax payers, the issue is in fact not so straight forward.
IFAs must identify whether their clients are investing for capital gains or income, and whether they are investing for the long or the short term. Where growth is driven wholly, or largely, by dividend (income equities), interest (fixed interest) and rent (property), then an investment bond is likely to look attractive from a tax perspective.
This is because unlike collective investments UK dividend income, which is reinvested in the life assurance fund, suffers no further tax. When cashing in the policy, the tax payer receives a 20% tax credit on the chargeable event gains. But, where growth is driven wholly, or largely, by capital gain (growth equities), then a collective investment is likely to look attractive from a tax perspective.
Investing for Income
Bonds have always been used by financial advisers as an effective tax planning tool for their clients, and they will continue to be so. As you can see in Figure 1, the assets within the bond perform well against the same assets in a collective.
In Figure 2, the effect of the preferential tax treatment of the net dividend, over a relatively short period of time, means that investment bonds may still be suitable, especially when you consider the other beneficial features of investing in a bond such as tax free switching tax, deferred withdrawal and IHT planning.
Anecdotal evidence tells us that people who invest in investment bonds tend to be older and wealthier investors who are looking for income when they're retired and become a basic rate tax payer. Therefore the need for income for many is, and remains, a key consideration despite the Chancellor's changes to the CGT rules.
However, in turbulent times, how confident can investors be that their income won't fall? A recent survey conducted on behalf of The Hartford by YouGov revealed widespread uncertainty and concern among investors about the current market volatility. Investors over the age of 45 are already feeling the effects of recent turmoil in the equity markets, and are experiencing greater levels of anxiety about their finances. Those over age 55 expressed the most concern.
The introduction of guaranteed variable annuity products otherwise known as living benefit products enable clients to lock a percentage of the growth during the good years (up until age 75), thereby increasing their income. Then when markets fall they can protect these gains to provide a guaranteed level of income that can never go down.
Taxation is an important consideration when determining the appropriate tax wrapper for clients. However, taxation is not the only consideration.
Investment bonds have a number of features that are not available with a collective, not least the advantage of a living benefit style guarantee with some more innovative products. While there will be times when a collective would provide the best tax wrapper, bonds remain an attractive and financially sound method of financial planning.
Figure 1. Higher rate tax payers.
Term: ten years.
- Investment of £100,000
- Net dividend. 3.5%
- Growth. 2.0%
- Interest. 0.0%
- Collective after ten years. £154,911
- UK bond after ten years. £156,652
Difference in favour of a bond. £1,741
Figure 2. Higher rate tax payers.
Term: five years.
- Investment of £100,000.
- Net dividend. 3.5%
- Growth. 2.0%
- Interest. 0.0%
- Collective after five years. £125,317
- UK bond after five years. £124,557
Difference in favour of a collective. £760.
Achievements, charity work and other happy snippets
Laughable excuses for persisting
Spent 56 years at Schroders
Warns on profits