Understanding the 5% Tax Deferred Allowance for Bonds Q&A

Q: What is the 5% tax deferred allowance?

A: This is a rule in tax law which allows investors to withdraw up to 5% of their investment into a bond, each policy year, without incurring an immediate tax charge.

Q: Why is the 5% tax deferred allowance important?

A: This is used in the calculation to determine if an Excess Chargeable Gain occurs. This is particularly important if large partial withdrawals across all the segments/clusters of a bond have been made in the policy year. 

If withdrawals (regulars or partial) are taken which exceed the accumulated tax deferred allowance this can cause a large ‘artificial’ or Excess Chargeable Gain.

This can potentially cause a large tax liability, which bears no correlation to the economic performance of the bond.

Q: How do you calculate the 5% tax deferred allowance?

A: It's easier to do this by policy year. Here are some pointers to work out the available tax deferred allowance: 

For the first year, compare the tax deferred allowance each year (5% of the investments in) to the withdrawals (including OAC) taken that year:

•  if the withdrawals are higher, this creates an excess chargeable gain which arises at the end of the policy year

• if the tax deferred allowance is higher, then there is no gain and any unused allowance will carry forward to be used in future years

•  there is no time limit on how long it can be carried forward, as long as the bond is intact, the accumulated allowance can be ‘swept up’.
  

Going forward into the second and subsequent policy years, compare the tax deferred allowance (5% of the investment in + unused tax deferred allowance from previous years) to the withdrawals (including OAC) taken that year:

• if the withdrawals are higher, then this creates an excess chargeable gain which arises at the end of the policy year.

•  if the tax deferred allowance is higher, then there is no gain and any unused allowance will carry forward to be used in future years.