While we did not get an income tax increase in the Budget – and knew ahead of time that we would not – we did see a rise in the taxation of investment income.
From 6 April 2026, the rate of tax on dividends paid by basic-rate taxpayers will increase by two percentage points, from 8.75% to 10.75%. The rate for higher-rate taxpayers will rise by the same margin, from 33.75% to 35.75%. The additional rate remains unchanged at 39.35%.
Further changes follow from 6 April 2027. A new property income tax will be introduced, with rates of 22%, 42% and 47% for basic-, higher- and additional-rate taxpayers respectively. From the same date, the rate of tax on savings income will also increase by two percentage points for all taxpayers, taking rates to 22%, 42% and 47%.
It is worth remembering that savings income includes not only interest and annuity income, but also chargeable gains arising under investment bonds.
The fact that dividends remain untaxed at the life policyholder fund level is an argument for using bonds as a tax shelter
Late on Thursday 4 December, the Finance (No 2) Bill was published. At just over 550 pages – plus a further 480 pages of explanatory notes for those short of Christmas reading – it is substantial, though it does not implement all the Budget announcements. What it does confirm is that from 2027/28:
- The policyholders’ tax rate for UK life companies – the tax borne within the UK life fund – will increase from 20% to 22%. This applies to all income other than dividends, as well as to capital gains.
- The corresponding tax credit used when calculating tax on chargeable gains will also rise from 20% to 22%. As both the savings rate and the tax credit increase by two percentage points, higher-rate taxpayers will continue to pay 20% on chargeable gains, with additional-rate taxpayers paying 25%. For offshore bonds, which do not benefit from a tax credit, the equivalent rates will be 42% and 47%, with basic-rate taxpayers paying 22%.
Against this backdrop, it is helpful to illustrate the effective overall tax rates borne by the main investment routes: collective investments, UK bonds and offshore bonds.
These illustrations inevitably have limitations, as they consider only a single year and ignore the benefits of tax deferral – such as 5% withdrawals – and top slicing. However, they do help illustrate the broader picture.
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Take, for example, a higher-rate taxpayer earning interest through a fund held within a UK bond in 2027/28. They would be subject to:
- 22% tax within the life company, and
- 20% (being 42% minus 22%) on the chargeable gain when realised.
These rates are compounded rather than cumulative. As a result, £100 of gross interest would net down to:
[£100 × (100% – 22%)] × (100% – 20%) = £62.40
This equates to total tax of £37.60, or 37.6%, through a UK bond, compared with tax of £38 and a net receipt of £62 when held via a UK or offshore collective fund.
The fact that dividends remain untaxed at the life policyholder fund level provides an even stronger argument for using bonds as a tax shelter.
Outside a UK bond, from 2027/28 a £100 dividend will net down to £89.25 for basic-rate taxpayers, £64.25 for higher-rate taxpayers and, as now, £60.65 for additional-rate taxpayers.
For larger investments, informed modelling will often be required to determine the optimal after-tax outcome
Where dividends are instead held within a bond and extracted as chargeable gains, the corresponding net receipts would be £100, £80 and £75 respectively – a material improvement compared with dividends taxed outside an investment bond.
None of the above takes account of charges or any available dividend or personal savings allowances.
The summary table below illustrates effective wrapper tax rates, above any available dividend or personal savings allowance.
The tax-focused conclusions are slightly altered by the upcoming changes, but the broad position remains. In general, capital gains are best held within collectives, while the opposite is true for dividends, where investment bonds – particularly UK investment bonds – remain worthy of consideration for UK taxpayers.
In practice, the growth of many investment funds reflects a mix of dividends, capital gains and, in some cases, savings income such as interest. For larger investments in particular, informed modelling will often be required to determine the optimal after-tax outcome.
In some cases, allocating assets across different wrappers may be the most effective approach.
Tony Wickenden is MD of Technical Connection, an SJP Group Company