Life insurance investment bonds – a reminder of the tax planning opportunities
The advantageous manner in which onshore life insurance investment bonds are taxed provides tax-planning opportunities, which are often overlooked. Here is a reminder of the main advantages for an individual investor.
Tax deferral
Although the insurer may have paid tax on the underlying funds of up to 20% (in practice it is often significantly less), the investor only has a potential tax liability when there is a chargeable event. A chargeable event is normally deferred until death (usually of the last remaining life assured – some policies can have one owner, but up to six lives assured), surrender (encashment), assignment (transfer of ownership) for money or money’s worth, or a withdrawal in excess of the 5% allowance (see below). It is only then that a potential liability to income tax arises.
5% allowance
Up to 5% of the premiums invested can be withdrawn each policy year (until 100% of the initial premium(s) has been withdrawn) without an immediate liability to tax. This allowance is cumulative, i.e. if no withdrawals have been taken in, the first five years up to 30% of the initial premium paid can be withdrawn in year six with no immediate liability to tax. Withdrawals taken within this allowance are included in calculating the chargeable event gain arising on termination of the policy.
Tax saving
The investor receives a credit for 20% tax. For the basic rate, taxpayer there is no further liability and a higher rate taxpayer is effectively charged at 20% (40% less the lower rate credit of 20%). This tax is applied to a net figure – alternative investments gross up the profit tax it at 40% and then allow credit for the tax already paid. For example, compare £80 of UK interest received with an £80 gain on an onshore policy, for a higher rate taxpayer.
Interest Bond Gain
Interest Bond gain
Net interest/gain £80 £80
Tax deducted at source or paid on
underlying fund £20 £20
Grossed up income/gain £100 £100
Taxable income/gain £100 £80
Higher rate tax @ 20% £20 £16
Income (after tax) £60 £64
Total tax suffered £40 £36
Effective tax rate 40% 36%
The life policy tax treatment equates to a maximum effective tax rate of 36% (assuming tax within the fund is 20%). Non-taxpayers and starting rate taxpayers cannot reclaim any tax suffered on a life insurance investment bond.
Preserving tax credits
The tax deferred 5% allowance has become increasingly important. Child Tax Credit and Working Tax Credit provide benefits that are withdrawn on a proportionate basis where ‘taxable income’ exceeds a certain limit. However, withdrawals from a life insurance investment bond within the 5% allowance are not regarded as ‘taxable income’ for these purposes.
Assignment
Life policies, including life insurance investment bonds, are unique – they are the only equity-based investment it is possible to give away (or assign) to someone other than the spouse without triggering a potential liability to income or capital gains tax. On an assignment a chargeable event gain will only arise where the assignment is for money or money’s worth – i.e. the policy is sold. The ability to assign policies without incurring tax provides planning opportunities – for example, a higher rate taxpayer could give their policy to their basic rate tax paying spouse or adult child. Similarly, a policyholder could transfer an existing policy (or a number of segmented policies) to a trust established for their children or grandchildren, or trustees could transfer a policy to an adult beneficiary. For any gift to be effective for tax purposes, it must be made with ‘no strings attached’.
Switching
Bonds can allow investors to change their investment strategy without having to worry about the tax consequences as switches between funds within the bond can be made with no immediate personal tax liability.
Top-slicing relief
A chargeable event gain on a life insurance investment bond can result in the policyholder becoming liable to higher rate tax, even though they would not otherwise pay tax at this rate. Top-slicing relief can help to reduce the liability to tax in these circumstances. Top-slicing relief reflects that the gain has accrued over all the years of the policy’s life and helps avoid the unfairness of taxing the gain as if it had all arisen in one year. On termination of the policy (e.g. a death claim or encashment), the total gain is divided by the number of whole policy years and the resulting slice is added to the policyholder’s total income for that year to see if any of the gain should be taxed at the higher rate. It is only that part of the slice that falls above the basic rate limit that is taxed at the higher rate, multiplied by the number of policy years. If none of the slice falls above the basic rate limit, there is no further tax to pay on the bond gain.
Tax planning with pensions
Combining personal pension contributions with top-slicing relief can be extremely effective for tax planning purposes. This is because where personal pension contributions are paid, additional relief for higher rate taxpayers is given by extending the basic rate band.
Consider an example where an onshore life insurance investment bond is cashed in after being held for just over 15 years and the top-sliced gain exceeds the basic rate limit by £3,600.
The tax liability arising on the chargeable event gain will be £10,800 (£3,600 x 20% x 15). Funding a net personal pension contribution of just £2,808 will reduce this tax to zero because the basic rate band extends by exactly the £3,600 required to cover the top-sliced gain.
This planning not only saves the investor £10,800 in tax but will also provide them with a pension fund worth £3,600 initially. Benefits in excess of £14,000 can be provided by a net outlay of £2,808. The total tax saving is more than £11,000 – an effective rate of tax relief of 322%.
Every care has been taken to ensure that this information is correct and in accordance with our understanding of the law and HM Revenue & Customs’ practice. The law and HM Revenue & Customs’ practice are subject to change.