Insights and opinion
7 min read 29 Aug 23
For most people income is essential for day to day living but it’s also attractive for investors. Income (particularly dividends) tends to form a significant part of the overall return. With interest rates at current levels even cash can now provide considerable levels of interest. But can you have too much income when it comes to investing?
It really depends on how that income is going to be taxed. Obviously ISAs and pensions can be used to provide tax efficient income but when there’s money to invest in excess of these allowances Bonds and OEICs come into play.
Take John for example.
John is aged 68 and semi-retired. He receives a mixture of salary and pension totalling £45,000 p.a. He also has £4,500 of dividends from an OEIC portfolio, and interest of £1,500 from his cash savings. His total income before tax is £51,000 making him a higher rate taxpayer. He has £200,000 to invest for the next 5 years when he plans to fully retire. On retirement his pension will provide him with £30,000 p.a.
John can afford to fund his ISA without touching his new investment so his adviser recommends he invests in a diversified portfolio of OEICs. This is forecast to produce an annual return made up of dividends (3%), interest (2%) and capital gains (1%). But how will tax impact the returns from this investment taking into account his current and future tax position?
OEICs are relatively transparent from a tax perspective. They benefit internally from virtually no tax payable on income or gains from the underlying investments. The potential drawback is that the investor is assessed instead, and the rates of tax payable depend on whether the OEIC generates dividends or interest.
As a higher rate taxpayer, John is entitled to a personal savings allowance of £500 in which interest is taxed at 0%. He can also make use of the dividend allowance so the first £1,000 of dividends are taxed at 0%. Both of these allowances are being used by his current investments so any income from a new OEIC investments will be taxed at basic or higher rate (interest is taxed before dividends so some of the existing dividends will be pushed into higher rate due to the additional OEIC interest).
At the end of year 1 if John invests in his OEICs directly and reinvests the net income, his portfolio would be worth £208,436. At the end of 5 years and assuming his annual exempt amount has been used against his existing portfolio, he would have a small amount of CGT on disposal. The net proceeds received would be £246,181.
But what if he had wrapped that OEIC portfolio in an investment bond? Although the same portfolio would generate the same returns, bonds themselves do not produce income. This means there is no tax payable by the investor until there is a chargeable gain, which will normally be on encashment.
The internal taxation of offshore bonds is relatively straightforward. Offshore life funds don’t pay tax on dividends, capital gains, or other income received, such as interest. The internal taxation is therefore similar to an ISA or pension (or potentially an OEIC!) but when you encash you need to account for any gain.
The taxation of UK life funds (onshore bonds) is a bit more complicated because the life fund is taxed differently depending on type of return from the underlying investments.
The internal effective rate of tax will depend on how much of the return comes from dividends and how much from taxable income and gains. Where some of the return is made up from dividends the internal effective tax rate will be less than 20%.
When a chargeable gain occurs the policyholder will be assessed on the arising gain as savings income so the same allowances and rates that apply to interest apply to bond gains. Onshore gains come with a 20% tax credit. If the full gain when added to other income crosses into the higher or additional rate bands, top slicing relief may be used to reduce the tax liability. The effect of top slicing is to spread the gain over the number of years the policy has been in force so you are effectively taxed on a slice of the gain based on your income in the tax year of the gain. This means if you pick a good year to trigger a gain you can end up with little or no tax to pay.
Going back to John, if he were to wrap his OEIC portfolio within an offshore bond and fully encash after 5 years when he has income of £36,000 p.a. (£30,000 pension, £1,500 interest, £4,500 dividends), he would end up with £251,686 in his pocket. This includes an assumed additional wrapper charge of 0.2% p.a. but is still £5,505 more than he would have received by investing in the OEICs directly.
If he had wrapped the investments in an onshore bond with the same additional cost, the net proceeds on encashment would be £257,464 (£11,283 more than if he had invested directly).
The ability to shelter income from a high level of tax during the investment term and defer gains can be a valuable planning tool, especially for a higher rate taxpayer who will become a basic or non taxpayer further down the line. Keeping the “income tap” switched off by investing in a bond can also help those individuals who are on the cusp of one of the tax traps (loss of personal allowance, child benefit tax charge) where an income producing investment could cause further tax liabilities.
As with all financial planning however, there’s no one size fits all solution. Our Tax Wrapper Comparison Tool provides a quick and easy alternative to a pen and paper if you want to crunch the numbers for a particular client.