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Tax on bonds held within trust

Tax | Inheritance Tax Helpful? 4

Asked by jemnetley, submitted 22 October 2012.

Open Quote This is about the 10 year tax rule on two Skandia Capital and Income Bonds in Trust. We can take £5k out each per year 'tax free' and when it was set up HMRC said we didnt need to submit an annual tax return but I understand that at the 10 year point there is a possible tax charge on any increase in value.

How does this work? Am I right in assuming it is on any growth in the fund since the start date but not taking into account the withdrawals made?

The reason for this is that we have not taken out the full amount every year and and I was planning to roll these amounts up and 'take up the slack/profit' and start an ISA for each child. This would effectively reduce the overall growth back down to close on the original invested amount and reduce any tax bill. In subsequent years until the 10 years are up, we would take the maximum out and reinvest in an ISA.

Is this a feasible solution or am I missing something?
End Quote

Answered by Justin on 26 October 2012

There are two issues here, the taxation of the trust and the taxation of the investment bond held within.

Let's start with the bond, ignoring for a moment any restrictions the trust may place on withdrawals. You're allowed to withdraw up to 5% of your initial investment every year without further tax to pay at that time - it's not classed as income which is useful when held in a trust (as income above £1,000 is taxed at 50%, although some/all of this can be reclaimed by beneficiaries receiving income).

Note: this is not the same as tax-free. If the bond is held onshore then both gains and income are subject to basic rate tax (or thereabouts) within the bond, so some tax has already been paid. If held offshore this internal tax is not deducted. But, either way, any further tax owed will be collected (as income tax) when the bond is eventually surrendered, via a calculation called top-slicing (more details on our life investments page).

The 5% withdrawal allowance is cumulative, i.e. if you missed some years you can make a bigger withdrawal(s) to catch up, provided you stick to the allowance overall.

The taxation of the trust depends on the type of trust. The 10 year rule you're referring to is called a periodic charge and applies to discretionary trusts, including accumulation & maintenance, interest in possession, loan and discounted gift trusts.

The periodic charge is effectively applied at 6% of the trust value exceeding your nil rate band (less any chargeable gifts made within the previous 7 years) every 10 years. Any capital paid out between periodic charges (which would include the 5% withdrawals if paid out to a beneficiary) is effectively taxed on a pro-rata basis as an 'exit' charge (at the same tax rate as the previous periodic charge).

Assuming your trust falls under the periodic charging regime, the net outcome is that if the trust value at 10 years is below your nil rate IHT band (currently £325,000), taking into account other non-IHT exempt gifts made over the previous 7 years (including any other trusts you may have set up), then the periodic charge probably won't apply.

Yes, you could withdraw unused 5% withdrawals to reduce the 10 year value potentially subject to the periodic charge, but bear in mind they might be subject to an exit charge, if applicable.

You'll also need to check the provisons of the trust to see how much income/capital, if any, may be withdrawn and to whom it may be paid.

As this can be a complex area, I'd suggest double checking with your financial adviser as they should have the precise details of the trust to hand.

Please note this answer does not constitute a recommendation or financial advice and should not be relied upon when making specific investment or other financial decisions. You should always undertake your own research into whether a product or service is appropriate for your needs and, if necessary, use a qualified professional adviser.

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