Investment bond taxation – partial withdrawal or full segment encashment
Investment bonds are taxed under the unique chargeable events regime and as such, provide flexibility in terms of how funds can be withdrawn and, often this can be achieved in a tax-efficient manner as explained in this article.
An investment bond is essentially a savings product. It is a whole of life policy funded by a single premium or one or more single premiums. It can be written on a single life basis or on a multiple life basis and the sum assured will be paid depending on the terms of the policy, for example, joint life first death, or joint life second death.
A bond can be issued as a single policy or as a segmented policy – i.e., divided into a number of identical mini-policies. A segmented policy provides flexibility from a tax perspective as tax can often be minimised by encashing one or more segments regularly over a period of time or by assigning segments, to an individual thereby making an outright gift for inheritance tax purposes.
A bond is a non-qualifying policy which means an income tax liability can arise when a chargeable event occurs. This is usually, when the bond is fully surrendered, it matures, on death of the last life assured or when excess withdrawals are taken from the policy.
A unique feature of an investment bond is that it is possible to take withdrawals of up to 5% per annum of the investment amount over 20 years. This amount is tax deferred which means no immediate liability to income tax would arise, however the capital withdrawals would be considered when calculating the chargeable event gain figure on full encashment of either policy segments or the whole bond. Looking at this facility then, if someone invested £100,000 in an investment bond, they could withdraw £5,000 per annum for 20 years. In addition, it is important to note that this amount is cumulative, so if no withdrawals were taken for five years it would be possible to withdraw £25,000 without incurring an immediate liability to income. However, if the client wanted a higher amount which exceeded the cumulative withdrawal amount, any excess would be taxable. So, for example, if they wanted £30,000 in year five, £5,000 would create a chargeable excess and would potentially be subject to income tax depending on the client’s income position.
As mentioned earlier, however, it is possible to withdraw the required sum in a tax efficient manner in most cases. This is best illustrated by an example which sets out the various options available.
Example:
James has recently sold his holiday home and has decided to invest the proceeds in an investment bond with a view to being able to take withdrawals as and when required.
He invests £200,000 in an investment bond which is split into 20 segments.
Five years go by and due to unforeseen circumstances, James needs to raise £150,000 from his bond.
At that time the bond is worth £240,000.
James has the following options:
1. Take a partial withdrawal across all policy segments
If James were to take a withdrawal across all policy segments, any amount over and above the cumulative tax deferred allowance would generate an excess chargeable event gain.
£200,000 x 5% = £10,000
£10,000 x 5 years = £50,000
If James were to withdraw £150,000, this would result in a chargeable event gain of £100,000.
Top-slice = £20,000
2. Encash a number of policy segments
James could decide to surrender a number of policy segments to raise the funds he requires.
If the bond is worth £240,000, surrendering 13 segments would provide him with £156,000, calculated as follows:
£240,000/20 segments = £12,000
£12,000 x 13 segments = £156,000
The chargeable event gain in this scenario is based on:
[surrender value per segment – investment amount per segment]
£240,000 / 20 = £12,000
£200,000 / 20 = £10,000
Therefore, the chargeable event gain would be:
£12,000 - £10,000 = £2,000
£2,000 x 13 = £26,000
Top-slice = £5,200
3. Fully surrender the bond
James’ final option would be to fully surrender the bond, although this will provide him with more funds than required.
The chargeable event gain in this scenario would be based on:
[surrender value – investment amount]
£240,000 - £200,000 = £40,000
Top-slice = £8,000
In each case, the chargeable event gain must be added to James’ other income to determine the amount of income tax that may be payable and of course, he may be able to benefit from top-slicing relief, if applicable. As a reminder, top-slicing relief operates to potentially reduce or negate any tax charge on realised chargeable gains. Broadly speaking it operates by dividing the actual gain by the number of full policy years that the bond has been in force and then adding the result of the division to other income to determine if and if so, how much of the gain falls above the higher rate threshold. Its only this part that will trigger a higher or additional rate liability . The liability calculated on the slice is then multiplied by the number of years the bond has been in force to arrive at the liability on the gain. If the top slice falls entirely under the threshold above which higher rate tax becomes payable, then there is no liability on any of the gain.
If James had income of say, £32,000, there would be no further income tax payable on the chargeable event gain on an UK bond if he chooses option 2 or 3 after taking account of top-slicing relief. Whereas if he chooses option 1, the chargeable event gain of £100,000 added to £32,000 causes him to lose his personal allowance (see below) although for the purposes of calculating top-slicing relief he may be able to benefit from a personal allowance.
The calculation below is carried out in line with HMRC’s calculation method and shows the income tax he will pay:
Step 1 – Calculate loss of personal allowance and tax on income
| Income | £32,000 |
| Bond gain | £100,000 |
| £132,000 |
As a reminder the personal allowance is reduced by £1 for every £2 over £100,000. Therefore, for the current tax year the personal allowance is lost once total income exceeds £125,140 (based on a personal allowance of £12,570).
Tax on his income
| Non-savings | Savings | |
| Income | £32,000 | |
| Bond gain | £100,000 | |
| Tax payable | ||
| £32,000 x 20% | £6400 | |
| £500 x 0% (PSA) | £0 | |
| £5200 x 20% | £1040 | |
| £94,300 x 40% | £37,720 | |
| £45,160 | ||
| less tax treated as paid | £20,000 | |
| £25,160 |
Step 2 – Calculate tax on the bond gain
| £5200 x 20% | £1040 |
| £94,300 x 40% | £37,720 |
| £38,760 | |
| less tax treated as paid | £20,000 |
| £18,760 |
Step 3 – Calculate the top-sliced gain
| £100,000/5 | = £20,000 |
Step 4 – Calculate tax on the top-sliced gain
| Income | £32,000 |
| Top-slice | £20,000 |
| £52,000 | |
| less PA | (£12,570) |
| £39,430 | |
| Tax on top-slice: | |
| £500 x 0% (PSA) | £0 |
| £17,770 x 20% | £3554 |
| £1,730 x 40% | £692 |
| £4246 | |
| Less tax treated as paid | £4000 |
| £246 | |
| £246 x 5 | = £1,230 |
Step 5 – Top-slicing relief (step 2 less step 4)
| £18,760 - £1,230 | = £17,530 | |
| James’ revised income tax position after taking account of top-slicing relief would therefore be: | ||
| Non-savings | Savings | |
| Income | £32,000 | |
| Bond gain | £100,000 | |
| Tax payable: | ||
| £32,000 x 20% | £6400 | |
| £500 x 0% (PSA) | £0 | |
| £5,200 x 20% | £1040 | |
| £94,300 x 40% | £37,720 | |
| £45,160 | ||
| Less tax treated as paid | (£20,000) | |
| Less top-slicing relief | (£17,530) | |
| £7630 | ||
As James didn’t benefit from a personal allowance, this has resulted in him paying more income tax on his other income of £2,514 (i.e., £12,570 x 20%).
Things to bear in mind:
Broadly, when clients require funds from their investment bond, it is important to consider the various options available. Obviously, tax will play a big part in deciding which route to choose. However, the option that produces the smallest chargeable event gain may not be the right choice especially where the individual is a non or low-rate taxpayer as they could realise a larger chargeable event gain without having to pay any income tax.
It is vital that the income position of the client is considered, because if they incur a large chargeable event gain this could result in them losing some/all of their personal allowance as illustrated above. For these purposes the full chargeable event gain must be added to their other income to determine the position.
It is also important to consider when the chargeable event arises, so for example, if a partial withdrawal is taken, the chargeable event will arise on the last day of the policy year whereas with a full encashment the chargeable event gain will arise immediately. This means that the tax year in which a chargeable event gain is taxed could differ depending on how the withdrawal is taken.
Also, it is advisable to carry out calculations prior to taking any action so that the client fully understands their position depending on which option is chosen.