Investment income projection

EdInvestor

MJSW

MJSW wrote:

It's no wonder there is confusion about this if an IFA uses the terms income and capital interchangably, and Norwich Union call them income but you then categorically state "Its withdrawal of capital (upto 5% p.a.)". I think the reality is that in most cases the 5% withdrawals will effectively be a combination of both income and capital. If the income from the underlying investments less the charges is less than the amount withdrawn, then the excess is effectively coming from the capital . If the income from the underlying investments less charges is more than the withdrawals, then effectively it is all coming from the income.

This sounds logical, but surely it's not so? Isn't the 5% withdrawal allowed tax free because it's a return of your own capital: if it was income, it would be taxed in the usual way?

Isn't it a similar case to a purchased life annuity, where the tax is lower than a compulsory purchase pension fund annuity because in the former you are not taxed on the part of the payment which represents your own capital being returned to you?

oceanblue_3

I have just typed "Age Allowance Trap" into google. This was the first link it came up with

http://www.arch-fp.co.uk/investments_and_age_allowance.htm

I think it deals with all the topics that we have discussed.

MJSW

It doesn't remotely deal with the issues we have discussed. The word dividend does not appear in it once, and as we are discussing the additional tax arising on aditional dividends rather than tax on other income, that is rather crucial! I have already stated several times that the effective rate of tax on additonal income such as pensions is 33%. We are discussing the rate applicable to additional dividends, which is 11%. As you should be aware (but don't appear to be) pensions in the basic rate are taxed at 22%, whereas there dividends are taxed at 10% with a 10% credit, so effectively nil. Therefore obviously the effective rate of tax for the different types of income is different.

I note you have failed to explain why you consider telling a client the effective rate on dividends is 33% when the additonal tax they would pay is up to 11% is "accurate" and "easily understood".

EdInvestor

From OB's Friends Provident link

...any liability to tax on the first 5% of regular withdrawals of ‘income’ is deferred until the bond is encashed. The first 5% of ‘income’, therefore, is not taken into account for the purposes of the age allowance threshold. Furthermore, if the 5% allowance is not taken in a year it can be accumulated so that a larger sum can be taken out of the bond without an effect on age allowance in a later year.

Although there are many other factors to consider, not least the risk to capital, in theory just moving capital from a deposit account to a life assurance bond could take you out of the age allowance trap, saving you tax at an effective rate of 33%.... ( there they go again...)

If regular withdrawals in excess of 5% are taken from a life assurance bond the excess over 5% counts towards income for age allowance purposes. If you are currently taking an ‘income’ of say, 6%, from some form of life assurance bond, this means that only 1% will count towards your age allowance threshold.

Whilst life assurance bonds can be used beneficially to recover age allowance there is a potential problem in the year in which a life assurance bond is fully encashed. This is because the whole of the gain is included in your income for age allowance purposes. Although in practice, a procedure referred to as ‘top-slicing’ can reduce, or remove, any liability to higher rate tax on the gain from a life assurance bond, top-slicing cannot help to reduce the gain for age allowance purposes.

The whole of your age allowance could easily be lost in the year in which you encash a life assurance bond since the amount of chargeable gain plus other income frequently exceeds the age allowance threshold.

So when is 'income' not income, but actually capital? This tax is deferred, but what's actually being taxed - a "chargeable gain"? Is this a tax therefore on the bond's capital gains aka CGT? Or a tax on 'income' - it seems the latter because it could affect your age allowance....?

....the whole of the gain is included in your income.. for tax purposes

Bizarre.

MJSW

EdInvestor wrote:

Isn't the 5% withdrawal allowed tax free because it's a return of your own capital: if it was income, it would be taxed in the usual way?

The 5% withdrawal is allowed "tax free" (which probably not the correct term to use, as it may or not become taxable later depending on the circumstances then) because the tax legislation says it is. In the extract you quoted, I was looking from an investment perspective rather thana tax one. From tax perspective, withdrawals of under 5% aren't really either 'income' or 'capital', they are just ignored.

You need to get away from normal thinking in term of income and capital taxwise, investment bonds have a competely different set of rules. Tax on income and gains is paid within the bond by the insurance company. Withdrawals of under 5% are ignored at the time. If you withdraw more than 5%, then the cumulative excess above 5% pa is all chargeable to Income Tax. If you wanted to partially withdraw say 50% of the bond after 3 years, you would be taxable on 35%, even though most of that is your own capital. This problem can be avoided by dividing the policy into segments, so you fully encash half of the segments, rather than partially encashing all of it.

On full encashment, the amount assessable to Income Tax is typically calculated as:

Proceeds + partial withdrawals previously made - amount orignally invested.

You are deemed to have paid 20% tax already, so if after this gain you remain within basic rates there should be no futher tax unless the taxable element reduces the Age Allowance. Higher rate taxpayers have to pay an additional 20% tax on the proportion which falls into the higher rate band. This may be partially or fully reduced by 'Top Slicing Relief'. Essentially, this is an attempt to recognise that the profit has accrued over several years. For example if you had held for 10 years, the gain is divided by 10. If the tenth falls within basic rate band, then there isn't any higher rate tax to pay. If part of the tenth falls in the higher tax bracket, then the average rate of tax on the tenth is calculated, eg 30%, and that is then applied to the whole gain. If all of the tenth is still at higher rates, then higher rate tax is due on the full gain. It is a fairly complex system! If you want further information, I suggest you read the Inland Revenue's helpsheet. I can't remember the number of this of the top of my head, I think it is something like IR320 or IR330.

oceanblue_3

"I note you have failed to explain why you consider telling a client the effective rate on dividends is 33%" ..........where have I said this?

"It doesn't remotely deal with the issues we have discussed. The word dividend does not appear in it once, and as we are discussing tax on aditional dividends rather than tax on other income, that is rather crucial!" ......

What are additional dividends? Do you mean additional tax on dividends? If so, that has never been the issue; the issue has been how dividend income in excess of the Income Limit For Age Allowances of £19,500.00 affects the taxation of that "layer" of income, £4,390.00, just below the income limit.
This "layer" of income has already suffered tax at the rate of 22%; does it, effectively, suffer any more tax by dint of the existence of the dividend income in excess of £19,500.00? Yes or no?

EdInvestor

Thanks MJSW


Fortunately I fall into the following category as mentioned on the link:

Income from PEPs, TESSAs and ISAs, is especially valuable as it is not liable to tax in your hands and more importantly, for our purposes, does not count as income for the purposes of the age allowance threshold.

And thus I won't need to remember the intricacies of your previous post.The investment bond appears to have been created to solve a problem caused by people amassing too much pension income.

Very simple way to sort that out, folks.

What a relief

MJSW

oceanblue wrote:

Do you mean additional tax on dividends? If so, that has never been the issue; the issue has been how dividend income in excess of the Income Limit For Age Allowances of £19,500.00 affects the taxation of that "layer" of income, £4,390.00, just below the income limit.
This "layer" of income has already suffered tax at the rate of 22%; does it, effectively, suffer any more tax by dint of the existence of the dividend income in excess of £19,500.00? Yes or no?

No. Dividends form the top slice of income for tax purposes, and so the layer just below £19500 stays exactly where it was in the tax computation and it remains taxed at 22%.

"Effectively" the additional tax is 11% of the dividend as some income previously at 0% becomes taxed at 22%. I'm sure we've had this exact same discussion already?

And yet again, I note that you have still failed to explain why you consider telling a client the effective rate on dividends is 33% when the additional tax they would actually pay is up to 11% is in any way "accurate" and "easily understood". To quote yourself "their chief concern, however, is to receive accurate information regarding its effect on their income." The additional tax liability is 11% of the dividend - and according to you that is their chief concern. The 33% is of absolutely no concern to them - their tax liability doesn't increase by 33% of the dividend, it increases by (up to) 11%.

oceanblue_3

"And yet again, I note that you have still failed to explain why you consider telling a client the effective rate on dividends is 33%" .............and, yet again, I note that you have failed to tell me where I said this.

oceanblue_3

"Very simple way to sort that out, folks."

Wait, don't tell me, I know - a low cost SIPP! Or is this one of those situations where a low cost SIPP isn't so effective?