Case Study on Capital Gains Tax
Annie Giddens is 65 years old and has recently retired. She has decided to sell the flat she used in Birmingham as a pied-à-terre and realises that the sale will trigger a capital gains tax (CGT) liability. After a conversation with her son, Mark, Annie had an initial meeting with Rob Arnold, Mark’s IFA, a couple of weeks ago, to see whether there were any ways that the tax liability could be reduced. Annie has now come back for a second meeting with Rob.
‘Well Annie, I’m pleased to tell you that I think we may be able to reduce your tax bill’, starts Rob.
‘Well, bear with me, Annie, and let me take you through the figures before you make your mind up. As I said before, you get income tax relief on a pension contribution, and the way this works means that you only have to pay the net amount and the tax relief is claimed on your behalf, so rather than paying £18,000 across, you would only need to pay £14,040 for £18,000 to be invested on your behalf. You could then decide to draw the pension immediately and take 25% or £4,500, as a tax-free cash sum, reducing the effective cost to £9,540. The remaining £13,500 in the pension fund could be used to purchase an annuity, which I would estimate to be in the region of £750 per year, if it increases in payment each year at 3% to counter the effects of inflation. So, counting the first year’s annuity payment, the net cost comes down to £8,790, or less than half what you were expecting to pay a couple of minutes ago!’
‘Well, that certainly is starting to sound more interesting’, says Annie.
‘And, it doesn’t stop there, Annie. Remember I said we could also save some CGT and give you back your age allowance? We could also reduce your tax bill slightly by restructuring your deposit account so that the balance of the interest payments that you would have received this year are not paid until after 5 April 2008, so they fall in the next tax year.
Incidentally, the annuity payments from the pension would also be set up so you do not receive the first payment until the next tax year. I have calculated your revised tax liability, so let’s have a look – you’ll see that your net income has reduced by just under £300, but you will be receiving the deposit interest we have moved to next year in April, and this will be subject to less tax than if it had been paid this year. More importantly, you will also see that your income tax liability for this year has reduced by £711 and the CGT liability by £4,265, so in total we have saved almost £5,000 in tax. This reduces the effective cost of the pension contribution to £3,814, but, to be fair, let’s add back the reduction in your net income, so the net cost to you for providing the pension of £750 a year, increasing at 3% per annum, becomes £4,103.’
‘Rob, that sounds fantastic. I think I have even followed your calculations and it all makes sense to me. You did mention that there were some changes to capital gains tax from next April, would these save me even more?’ asks Annie.
‘What the chancellor is proposing is a simplification, which means a flat rate of tax of 18% and the abolition of the indexation allowance and taper relief from which you have benefited. In effect, your capital gain next year, if we assume the same CGT annual exemption of £9,200, would be calculated as £109,000 - £30,000 - £9,200 = £69,800 and this would be taxed at 18%, giving a potential liability of £12,564, or £515 more than if you realised the gain this year.’
‘So’, says Annie, ‘another example of tax simplification costing me money! It does make sense to do something this year, doesn’t it, and not only save tax, but increase my income. Do you have any other tricks up your sleeve?’
‘I do, but I’ll tell you some other time’, replies Rob.
‘Well Annie, I’m pleased to tell you that I think we may be able to reduce your tax bill’, starts Rob.
‘Well, bear with me, Annie, and let me take you through the figures before you make your mind up. As I said before, you get income tax relief on a pension contribution, and the way this works means that you only have to pay the net amount and the tax relief is claimed on your behalf, so rather than paying £18,000 across, you would only need to pay £14,040 for £18,000 to be invested on your behalf. You could then decide to draw the pension immediately and take 25% or £4,500, as a tax-free cash sum, reducing the effective cost to £9,540. The remaining £13,500 in the pension fund could be used to purchase an annuity, which I would estimate to be in the region of £750 per year, if it increases in payment each year at 3% to counter the effects of inflation. So, counting the first year’s annuity payment, the net cost comes down to £8,790, or less than half what you were expecting to pay a couple of minutes ago!’
‘Well, that certainly is starting to sound more interesting’, says Annie.
‘And, it doesn’t stop there, Annie. Remember I said we could also save some CGT and give you back your age allowance? We could also reduce your tax bill slightly by restructuring your deposit account so that the balance of the interest payments that you would have received this year are not paid until after 5 April 2008, so they fall in the next tax year.
Incidentally, the annuity payments from the pension would also be set up so you do not receive the first payment until the next tax year. I have calculated your revised tax liability, so let’s have a look – you’ll see that your net income has reduced by just under £300, but you will be receiving the deposit interest we have moved to next year in April, and this will be subject to less tax than if it had been paid this year. More importantly, you will also see that your income tax liability for this year has reduced by £711 and the CGT liability by £4,265, so in total we have saved almost £5,000 in tax. This reduces the effective cost of the pension contribution to £3,814, but, to be fair, let’s add back the reduction in your net income, so the net cost to you for providing the pension of £750 a year, increasing at 3% per annum, becomes £4,103.’
‘Rob, that sounds fantastic. I think I have even followed your calculations and it all makes sense to me. You did mention that there were some changes to capital gains tax from next April, would these save me even more?’ asks Annie.
‘What the chancellor is proposing is a simplification, which means a flat rate of tax of 18% and the abolition of the indexation allowance and taper relief from which you have benefited. In effect, your capital gain next year, if we assume the same CGT annual exemption of £9,200, would be calculated as £109,000 - £30,000 - £9,200 = £69,800 and this would be taxed at 18%, giving a potential liability of £12,564, or £515 more than if you realised the gain this year.’
‘So’, says Annie, ‘another example of tax simplification costing me money! It does make sense to do something this year, doesn’t it, and not only save tax, but increase my income. Do you have any other tricks up your sleeve?’
‘I do, but I’ll tell you some other time’, replies Rob.
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