Comparing Full vs Part Segment Surrender when withdrawing funds from a bond

5 min read 28 Feb 22

By The Technical Team

Deciding how to withdraw funds from a bond when the whole bond is not being encashed.

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 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:

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 3^rd 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.

Option 1

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

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.

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