When deciding whether to surrender all or part of a single- premium investment bond, whether issued by a life office resident in the UK or offshore, the special tax rules relating to gains on life insurance policies, which determine when chargeable events occur, must be considered.
Some clients may try to access their capital without advice. While no investment gain may exist, by taking a part-withdrawal equally across all policies, they could create a taxable gain, resulting in an unexpected tax bill. This is an area where the value of quality advice can be demonstrated.
The April Budget and the Finance Act 2009 further highlight the need for advice regarding how and when an encashment is made.
The new 50 per cent rate (the “additional” rate) for taxable incomes of £150,000 and above and the tapered loss of personal allowances for those with incomes above £100,000 could mean that action taken today has serious consequences in the future.
Under the chargeable events’ regime, withdrawals taken by partial surrender which exceed the cumulative 5 per cent tax-deferred allowance in any given policy year give rise to a chargeable-event gain and as such are liable to income tax. This type of chargeable-event gain is treated for tax purposes as having occurred at the end of the policy year.
The way a client could create a chargeable gain despite there being no investment gain can be illustrated with the following example.
Consider a client who invests £100,000 into a UK investment bond on June 1, 2008. The bond is issued as a series of 100 identical policies.
On April 30, 2009, the policy value is £100,000. On the same day, the client makes a withdrawal of £80,000 taken equally from each of the 100 policies within the bond.
This creates a chargeable event gain of £75,000, calculated as follows: £80,000 (withdrawal) less [ £100,000 (investment) x 5% deferred allowance (one year’s allow-ance available) ] = £75,000
This gain would be added to the client’s total income to calculate their resulting income tax liability. This could take the client’s income into higher rates of tax and up to an additional 20 per cent tax (£15,000) could be due, being the difference between the basic and higher rate.
To mitigate this liability, the client could fully surrender the policies before the end of the tax year. Where a policy is fully surrendered in the same tax year as the previous anniver-sary, the previous anniversary would not have been the end of the policy year, which will instead be extended until the date of full surrender. This means that there is no charge-able-event gain on the excess partial withdrawal, as it would not have ever occurred.
So, in the above example, if the bond had been fully encashed before April 6, 2010, the “excess withdrawal” could have been ignored. The full surrender would be treated as a chargeable event and would potentially trigger a tax charge, which would be zero in this case as there had been no investment gain.
When looking to fully or partially surrender a policy, there are number of key considerations to take into account which could affect the decisions made and the advice given:
- When does the gain arise for tax purposes?
- Should the gain be realised in 2009/10 or 2010/11?
- How much is added to the income?
- What rate of tax will be applied?
- What is the impact on personal allowances?
Seeking advice on when to make a partial withdrawal or to encash a bond fully can help reduce or negate any tax liability.
Advisers have a role to play in this area and being able to provide advice on bond withdrawals and encashment will further enhance the service that advisers offer to clients.
This article is based on Skan- dia’s interpretation of the law and HM Revenue & Customs practice as at October 2009.
Colin Jelley is head of tax and financial planning at Skandia