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Planning an exit – 5% allowance vs total segment surrender

An onshore bond is simply a tax wrapper - you may have clients that are more suited to an onshore bond than an offshore bond or a collective and so on, as each client is different.

However, onshore bonds can offer significant tax advantages to the right investor and, coupled with an effective exit strategy, can prove to be ideal.

One question when a client wants to withdraw money from the bond is, Should they use the 5% allowance or take total segment surrenders? The answer is, It depends! Before we look at a few examples, let’s consider the taxation of an onshore bond fund.

An onshore bond will pay some tax within the fund. Some may consider this a disadvantage but it can be an advantage. A life fund pays corporation tax on the income it receives and any gains it makes. Rental income and interest (fixed interest stocks) are taxed at 20%, UK dividend income is exempt with any capital gains achieved by the funds also being taxed at 20%. Until 31 December 2017 companies were able to apply indexation relief to these realised gains, but changes brought about by the Finance (No 2) Act 2017 mean that indexation cannot apply beyond 1 January 2018 – meaning the full 20% will now apply.

These taxes are equivalent to the 20% basic rate of income tax and, as a result, this is treated as being paid within the fund. However, even with indexation being frozen, the actual rate paid may be lower than 20% and generally around 16%-18% (depending on the type of assets held, the investment performance and the prevailing economic conditions).

A bond can grow without any personal tax charge and without any need to disclose income or growth providing withdrawals are within the 5% allowance. This makes bonds ideal for those who want a straightforward investment and minimum paperwork.

Also, no tax charges apply for any fund switches carried out within the bond wrapper when changing the underlying investment. This can favour those seeking active management or who want to periodically re-balance their investment.

5% allowance

Each year, a policyholder can take withdrawals of up to 5% of the premium paid in that year plus 5% of any premium paid in any previous years without an immediate liability to income tax. This is known as the ‘tax-deferred withdrawal’ facility and any allowance not used can be carried forward to future years. If no income is taken in year one, then 10% is available in year two and so on.

As well as the 5% allowance there is an overall maximum limit. Once 100% of the cumulative allowance has been used then any further withdrawals, regardless of the amount, are considered a chargeable event. So, for example, withdrawals of 5% each year can be taken for twenty years, 4% each year for 25 years and so on.

For tax purposes, withdrawals within the 5% allowance are considered return of capital.

This means that a policyholder can take annual withdrawals of up to the 5% allowance without reducing any of the following:

  • Personal allowance.
  • Age related personal allowance.
  • Working tax credits.
  • Child tax credits and child benefit.

Policy segmentation

When the policyholder requires money from the bond they can use the bond’s flexibility to choose a method to best suit their circumstances. Bonds are generally written as a series of identical policies, or segments, allowing amounts to be taken from the bond by:

  • Surrendering one or more whole policies – this is always a chargeable event and a chargeable gain could exist but this could be significantly lower than the gain on an excess withdrawal.
  • Partial surrender across all policies – a chargeable event is only triggered if the amount withdrawn exceeds the available cumulative 5% allowance.
  • When subsequently fully surrendering a whole policy and calculating the chargeable gain, previous withdrawals are factored in and any previous chargeable gains can be deducted.
  • A combination of the above, which could minimise any immediate tax liability by tailoring a withdrawal to the policyholder’s individual circumstances.

For example, an investment bond set up with £100,000 has been in force for 4 1/2 years. A withdrawal of £35,000 would generate a chargeable gain of £10,000 (£35,000 – (£100,000 x 5%) x 5) even if the bond value was only £99,000. If, when the whole gain is added to the policyholder’s income, they remain a basic rate taxpayer, a partial surrender keeping all the policies in force and allowing them the potential to grow in the future might be the best fit for the policyholder. However, if the policyholder is close to, or is already, a higher rate taxpayer, surrendering whole policies might be the best solution. Other considerations would be that the chargeable gain is treated as income and therefore could affect any income means tested benefits.

Case study

As mentioned, sometimes a combination of both could be the best fit. Let’s consider Anna who has a taxable income of £38,000:

  • She invests £100,000 into an investment bond which is segmented into 100 individual policies.
  • 3 ½ years later she wants to withdraw £60,000.
  • The value of the bond is now £120,000.
  • A part surrender would generate a chargeable gain of
    - £60,000 – (£100,000 x 5%) x 4) = £40,000.
  • Even with top-slicing relief Anna would have a tax liability on the part surrender.

She could:

  • surrender 40 policies for £48,000 generating a chargeable gain of
    - £48,000 - £40,000 = £8,000.
    - There is no tax liability on the £8,000 gain as, when added to her income, Anna remains a basic rate taxpayer.
  • AND
    - surrender £12,000 from the remaining 60 policies which is within the 5% allowance.
    - £60,000 x 5% x 4 = £12,000.
  • So, Anna can receive the £60,000 without paying any additional tax liability. However her future 5% allowance will be reduced to £3,000 each year based on the remaining 60 segments.

Conclusion

Care must be taken when deciding upon the right method of withdrawing money. The method that best suits a policyholder will depend on their personal circumstances both now and in the future, including whether they need to take regular withdrawals from the bond.

Kim Jarvis is a Technical Manager at Canada Life. She has worked in the life industry arena for over 20 years, with experience in trusts and their taxation, product development, the impact of new legislation on the industry and delivering training. She is an affiliate of the Society of Trusts and Estate Practitioners and a Chartered Insurer.

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Canada Life Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.

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Stonehaven UK Limited and MGM Advantage Life Limited, trading as Canada Life, are subsidiaries of The Canada Life Group (U.K.) Limited. Stonehaven UK Ltd is authorised and regulated by the Financial Conduct Authority. MGM Advantage Life Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority.