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Drawing more than the 5% annual allowance

Insurance Bonds are commonly used by investors to provide a regular form of income, which if limited to withdrawals each year of 5% of the initial premium, will be not be taxed for the first 20 years. These bonds, which may be taken out in the UK or offshore, can offer significant tax planning opportunities, but occasionally investors can be caught by a trap.

The 5% “tax free allowance” is cumulative. So if an investor draws nothing in years 1 and 2, he may draw up to 15% in year 3.  Withdrawals in excess of the 5% allowance are charged to income tax at the individual’s marginal rate of income tax, as are any withdrawals made once a total of 100% has been withdrawn (e.g. 20 years @ 5% per annum).

A recent case involved a Belgian man who acquired a single premium life assurance bond for over $1m. In the two years after paying the premium, he made withdrawals of most, but not all, of the funds in order to buy a house in the UK. As these withdrawals greatly exceeded the 5% allowance, chargeable event gains arose which meant that the investor had significant UK income tax liabilities. Two years later he encashed the remainder of the policy. Overall he made a small loss (i.e. the total withdrawals were less the original premium paid).

Despite having made an overall loss, the tax legislation does not allow any revision to reduce the earlier tax charges. However iniquitous it may seem, the consequence of this is that HMRC could force this investor into bankruptcy in an attempt to recover the income tax due.

As is common, the policy was written as a number of sub policies, but when the investor signed the forms requesting the withdrawals, he ticked the box indicating that there should be part withdrawals from each of the sub-policies. If instead he had ticked the box indicating that some of the sub-policies should be fully encashed, he probably would have had no tax liabilities at all. All this could therefore have been avoided if the investor had taken professional advice when completing the forms to make the withdrawals.

Personal portfolio bonds

In another recent case, not only did the investor withdraw more than 5% of the annual allowance, but one of the policies was classed as a “personal portfolio bond”.  Draconian anti-avoidance legislation deems such an investor to have made a 15% return (compounded) on the original premium. As a result he is assessed to income tax on that deemed income (regardless of the actual return of the underlying investments).

A personal portfolio bond consists of an insurance policy wrapper to hold underlying investments, where the investor has control over those underlying investments.

The information in this article is believed to be factually correct at the time of writing and publication, but is not intended to constitute advice.  No liability is accepted for any loss howsoever arising as a result of the contents of this article. Specific advice should be sought before entering into, or refraining from entering into any transaction.