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5 min read 28 Feb 22
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).
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.
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 circumstances, 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:
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 3rd insurance 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.
Beatrice could simply execute a part surrender to 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 |
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
Neither of these options will be entirely suitable if Beatrice requires proceeds of exactly £50,000.
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.
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.
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.
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