Full vs part segment surrender when withdrawing funds from a bond

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

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 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.

Option 1

Beatrice could simply execute a part surrender to raise £50,000.

This would result in a chargeable event gain as follows:

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.

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.

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.