Contents
1. Key Points
2. The fundamentals of the ‘5% rule’
3. Example of the cumulative 5% rule
4. Minimising the gain on a large part surrender
5. Example of minimising the gain on a large part surrender
6. Example of encashing just 3 segments and taking a £17,000 part surrender
7. Points to consider
Deciding how to withdraw funds from a bond when the whole bond is not being encashed.
Key Points
- The ‘5% rule’ for insurance bonds is available to individuals and trustees.
- Where cumulative 5% allowances are exceeded, the resultant gain bears no correlation to the economic performance of the bond.
- A significant part surrender can inadvertently create a chargeable event gain.
- Often a smaller gain can arise if the proceeds are realised by full segment surrender or a mixture of full surrender and part surrender from the remaining segments.
- Each case must be judged on its own merits using the figures relevant to that particular case.
- For some, the smaller gain is not always desirable. For example, a low taxpayer with an onshore bond gain.
- The calculations must be performed prior to any withdrawal being made.
The fundamentals of the ‘5% rule’
The ‘5% rule’ for insurance bonds is widely used and enjoyed by individuals and trustees.
Part surrenders of up to 5% of accumulated premiums can be taken without any immediate tax charge. Where there has been a part surrender, a calculation must be made at the end of the insurance year to see whether a gain has arisen and if so its amount. A gain will then only arise if, the part surrender value(s) received exceeds the available 5% allowance. Any allowance not used can be carried forward for use in subsequent years.
An investor can therefore withdraw 5% of a single premium investment each year for 20 years without a chargeable event occurring. The maximum allowance is 100% of any premium. The allowance will not accrue after 20 insurance years have elapsed but any unused allowance can be carried forward beyond that point (4% for 25 years perhaps).
Example of the cumulative 5% rule
Alan invested £100,000 on 1 January 20X8 and takes a single part surrender of £5,000 on 1 July 20X8. No gain will arise at 31 December 20X8 when the insurance year ends as the withdrawal is within the available 5% allowance.
If Alan had taken no withdrawals during 20X8, then he could withdraw £10,000 (5% + 5% of original premium) during 20X9 and no gain would arise at 31 December 20X9.
Minimising the gain on a large part surrender
Where cumulative 5% allowances are exceeded then the resultant gain bears no correlation to the economic performance of the bond. A significant partial withdrawal can therefore inadvertently create a chargeable event gain. In these circ*mstances, it may be more tax efficient to fully surrender individual segments than take a withdrawal across all segments. To generate an exact amount of proceeds it may be necessary to encash some segments and then take a part surrender from across the remaining segments.
This is best illustrated with an example:
Example of minimising the gain on a large part surrender
Beatrice who is a higher rate taxpayer invested £100,000 in a bond on 1 January 20X6. The bond has 10 segments.
On 1 May 20X8 when the bond is in its 3rdinsurance year, Beatrice unexpectedly needs to raise £50,000 from her bond. At that date, the bond has grown in value to £110,000. No withdrawals have previously been made.
Option 1
Beatrice could simply execute apart surrenderto raise £50,000.
This would result in a chargeable event gain as follows:
Surrender Proceeds | £50,000 | |
5% tax deferred allowance | (£15,000) | £100,000 x 5% x 3 |
Chargeable event gain | £35,000 | This would arise at 31 December 20X8 |
Option 2
Fully encashing the bond would give rise to proceeds of £110,000 and a chargeable event gain of £10,000 (£110,000 less £100,000). Given that the bond has 10 segments then the encashment of one segment would realise proceeds of £11,000 and a gain of £1,000. A full encashment gain would arise at the time of encashment i.e. 1 May 20X8.
Beatrice could therefore
- Encash 4 segments yielding proceeds of £44,000 and a total gain of £4,000, or
- Encash 5 segments yielding proceeds of £55,000 and a total gain of £5,000.
Neither of these options will be entirely suitable if Beatrice requires proceeds of exactly £50,000.
Option 3
Beatrice can encash 4 segments and then take a part surrender of £6,000 across the remaining segments. The calculations are as follows.
As noted above, the encashment of 4 segments will yield proceeds of £44,000 and a gain of £4,000. Beatrice then needs to take a £6,000 part surrender from across the remaining 6 segments.
Surrender Proceeds | £6,000 | |
5% tax deferred allowance | (£9,000) | There are 6 remaining segments meaning that the premium for those segments was £60,000. The 5% allowance is £60,000 x 5% x 3 |
Chargeable event gain | £Nil |
Therefore, if Beatrice fully encashes 4 segments and takes a part surrender of £6,000 from across the remaining 6, then that would give a total chargeable event gain of £4,000 arising at 1 May 20X8.
For completeness, if Beatrice decided to encash just 3 segments and then take a part surrender of £17,000 from across the remaining 7 segments, then that strategy would produce a larger gain.
Example of encashing just 3 segments and taking a £17,000 part surrender
Encash 3 segments yielding proceeds of £33,000 and a total gain of £3,000 at 1 May 20X8.
Proceeds from the encashment of 3 segments will yield proceeds of just £33,000 meaning that Beatrice needs to take £17,000 part surrender from across the remaining 7 segments.
Surrender Proceeds | £17,000 | |
(£10,500) | There are 7 remaining segments meaning that the premium for those segments was £70,000. The 5% allowance is £70,000 x 5% x 3 | |
Chargeable event gain | £6,500 | This would arise at 31 December 20X8 |
Therefore, if Beatrice fully surrenders 3 segments and takes a part surrender of £17,000 from across the remaining 7, then that would give a total chargeable event gain of £3,000 + £6,500 = £9,500.
Points to consider
In summary, where a withdrawal is required which significantly exceeds 5% limits then it may be the case that an encashment of some segments followed by a part surrender from across the remaining segments (where necessary) will produce a smaller gain. The following points are however relevant.
- Each case must be judged on its own merits.
- The smallest gain figure is not always desirable. For example, a low rate taxpayer with an onshore bond might prefer crystallising a larger gain if it gives rise to no tax implications at that time.
- The calculations must be performed prior to any withdrawal being made. Once a surrender or part surrender of a policy has been validly made, it cannot be reversed.
- Where a partial surrender gain which arises on the last day of the insurance year is followed by a full surrender in the same tax year then the partial surrender gain is ignored and instead the proceeds are brought into the final surrender gain calculation.
- Tax legislation allows a person who has made a part surrender giving rise to a gain to apply to HMRC to have the gain reviewed if they consider it is wholly disproportionate. Applications must be made in writing and received within 4 years after the end of the tax year in which the gain arose. A longer period may be allowed if the officer agrees. If the officer considers that the gain is disproportionate, then the gain must be recalculated on a just and reasonable basis.
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