Ruth, aged 66, has an income of £22,900 in 20010–11.

Ruth, aged 66, has an income of £22,900 in 20010–11. This is the maximum she can have without losing any personal allowance so she qualifies for the full amount for someone aged 65 to 74 of £9,490 and her tax bill for the year is set to be £2,682. However, she decides to cash in a single-premium life-insurance policy, making a gain of £2,000. This increases her income to £24,900. Although she is still a basic rate taxpayer and there is no tax for her to pay on the gain itself, her tax bill increases to £2,882. This is because her personal allowance is reduced by £1 for every £2 of income above £22,900. Therefore the £2,000 gain reduces her personal allowance by £1,000. This puts an extra £1,000 of her income into the basic rate tax band adding £200 to her tax bill.

In 2010–11 Jim, aged 48, has earnings of £43,000 and also makes a life insurance gain of £5,000 on a policy that has run for five years. At first sight, £875 of the gain falls within Jim’s basic-rate band, leaving £4,125 to be taxed at 40% – 20% = 20%, a tax bill of £825. However, because the gain takes Jim over a tax-rate threshold, top-slicing relief applies. The gain of £5,000 is divided by the number of years the policy has run, which is five. This gives an average gain or ‘slice’ of £1,000. So £875 of the slice falls within Jim’s basic-rate band, leaving £125 to be taxed at 40% – 20% = 20%. Therefore, tax on the slice is £25 and tax on the whole gain is reduced to 5 × £25 = £125.

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