It is vital for advisers to understand how single premium life assurance investment bonds are taxed to ensure their clients avoid unnecessary charges, writes Martin Pickles, technical adviser at SimplyBiz.
To understand the taxation of single premium life assurance investment bond returns, it is essential to know the basics. Funds can be withdrawn by two methods, partial surrender and full encashment, and great care needs to be taken in the manner in which withdrawals are made.
There is a 5% rule on bond withdrawals. Although often misquoted as being tax free, these withdrawals are in fact tax-deferred. The 5% withdrawals are based on the original investment amount and are available for each of the first 20 years on an aggregating basis, that is, if not used in the first year, 10% may be withdrawn in year two, and so on up to 100%.
What happens after 20 years? If no withdrawals have been made after 20 years, then up to 100% of the original investment can be withdrawn without creating an immediate tax liability. If the full 5% allowance has been used at the 20-year point, any further withdrawals will be chargeable gains and potentially liable to income tax.
Partial withdrawal planning
A partial withdrawal is deemed to take place at the end of the policy year and not when the actual withdrawal takes place. This could offer a tax planning opportunity if the withdrawal date and policy anniversary straddle tax years and the investor’s income is due to drop in the following year. Conversely, if income is set to increase, it could be more appropriate to effect a full surrender so the chargeable event takes place on the day of the withdrawal.
In the first 20-year period, if the 5% entitlement is exceeded, a chargeable gain occurs even if the investment as a whole is making a loss. This scenario is known as creating an artificial gain and can come as a shock to unwitting policyholders who think they are just accessing their original investment.
Investment return calculation
A true reflection of the investment returns achieved, gain or loss, is obtained on full encashment when the following formula is used:
(Surrender value + previous withdrawals) – (original investment + previous chargeable gains)
This formula is also used for encashment of whole segments, sometimes known as clusters, within a bond.
Top-slicing
Top slicing provides an indication of the average return and is used to determine any liability or exposure to higher or additional higher rate income tax. If any of the top slice sits in the higher or additional higher rate income tax bands, then tax is due on that portion at the appropriate rate, applied back to the total gain in appropriate proportion.
There is a difference in the top-slice calculation between onshore and offshore bonds. A partial surrender from an onshore bond would be taken back to any previous chargeable event or commencement of the bond if there were no previous chargeable events. The top slice on an offshore bond partial surrender is always taken back to the commencement date.
Partial surrender
The following example would apply to both onshore and offshore bonds: Dave invests £100,000 into a bond on 1 June 2009, split into 100 segments of £1,000. The 5% entitlement is £50 per segment, and therefore £5,000 of the total investment.
Consider the situation on 1 August 2011 (year three) when the bond is worth £110,000 and Dave wishes to withdraw £50,000 to help his son purchase his first property.
If Dave were to take a partial surrender across all segments, the chargeable gain would be calculated as:
£50,000 – £15,000 (three years at £5,000) = £35,000
Top slice gain: £35,000/3 = £11,666.67
As you can see, no reference is made to the current value of the bond and this calculation is the same no matter what the value of the bond is. Three years is used for the 5% entitlement, but it does not matter at what point in the year the withdrawal takes place because the withdrawal is deemed to take place at the end of the policy year.
Full encashment of segments
Alternatively, Dave could withdraw sufficient segments to release the required £50,000. Each segment is now worth £1,100. Therefore, 46 segments would yield £50,600, slightly over the required amount.
The chargeable gain is calculated using the above formula for a segment:
(Surrender value + previous withdrawals) – (original investment + previous chargeable gains)
In this case the calculation is: (£1,100 + £0) – (£1,000 + £0) = £100
Total withdrawal, £100 x 46 segments, gives a chargeable gain of £4,600.
Top slice: £4,600/2 = £2,300 (two full policy years at time of surrender).
There is a big difference between the chargeable gains and top slice under each route.
There is a big difference between the chargeable gains and top slice under each route.
As the intention is to withdraw a specific amount and maintain the bond, a partial surrender could appear to be the logical withdrawal method, but the consequences can be harsh for choosing the wrong route.
Key points
Withdrawals
Partial surrenders are deemed to take place at end of policy year. Full surrenders (segments or whole policy) take place on the day of encashment.
Top slicing
Partial surrender:
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Onshore bond, back to previous chargeable event or commencement if no chargeable events.
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Offshore bond, back to commencement.
Full surrender (segments or whole policy):
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Back to policy commencement, full policy years.
Top slicing can only limit any potential to a higher or additional higher rate income tax charge. The full gain is applied when calculating any loss of personal and/or age allowance.
