The planned reforms would change the way taxable income is calculated when money is taken out of investment bonds.
In a consultation paper published last week, HM Revenue & Customs set out three possible changes to the rules to ensure that individuals do not suffer from “disproportionate” tax bills when accessing their money early.
The three solutions, of which only one would be implemented, are: taxing the economic gain; deferring any excessive gains; or introducing a 100% allowance to repleace the current annual 5% tax free withdrawal.
Simple solution best
Rachael Griffin, financial planning expert at Old Mutual Wealth, said the “simplest” solution is to implement the 100% allowance which would replace the 5% tax free that policyholders can currently withdraw each year – instead enabling them to take out any amount at any point, up to 100% of their premium before being liable to tax.
“Once someone withdraws 100% of their premium, excess withdrawals are then taxed as economic gains.
“Two of the proposals; taxing the economic gain and deferral of excessive gains, both require complex calculations, and will impact all customers looking to make a withdrawal from their policy. It will make the withdrawal process more complicated and given some customers don’t fully understand today’s process I would argue it doesn’t help solve the issue,” added Griffin.
According to HMRC, deferral of excessive gains involves keeping the current rules, but including a benchmark level of gain (e.g. 3%), so that if large sums are withdrawn, a safety net kicks in to ensure the tax liability is at an appropriate level, and the gain rolls on to the next time a person takes money out. If the gain is still excessive, it will roll on again, and so on, up to maturity or full surrender.
Meanwhile, taxing the economic gain on each withdrawal would treat some of the withdrawal as premium instead of taxable income – ensuring that the amount which is tax liable is an appropriate fraction of what the policy will actually make.
Extreme tax
Griffen described the HMRC’s proposals as “much anticipated” although she had hoped it would grant insurers the power to rectify “mistakes” that occur in a small number of cases that result in “extreme tax consequences”.
“It was hoped that HMRC would give sanctions to providers to simply correct such cases, as this only impacts a small percentage of policyholders (HMRC quote 600 cases). Mistakes can happen and may lead to extreme tax consequences which are completely disproportionate to the growth received on the investment.
“This is what had prompted the review by HMRC,” she said.
Current rules
Under the current system, using part surrender policyholders can take out 5% of the money they have invested in a bond tax free every year over the lifetime of the bond, or with part assignment they can sell up to 5% of the policy every year, again tax free.
Investors buying these bonds, which are often made up of a series of single-life insurance policies, can either convert one of the policies into cash or convert segments of the bond and just pay income tax on any gain it has made – usually at their top rate of income tax. Or they can encash all the segments and pay income tax on the total gain in the bond.
Policy holders can also build up the tax free allowance over the duration of the bond to make lump sum withdrawals.
The Lobler case
One of the problems for those looking to make a large withdrawals in the early stages of their policies in excess of their 5% allowance, is they can often find themselves liable to pay income tax on the full amount of money withdrawn – a situation 600 policyholders in the UK are faced with, HMRC said.
This was the case in 2007 when Dutch national Joost Lobler was ordered by HMRC to pay $560,000 (£390,418, €495,000) in tax on the $1.42m he withdrew from a life insurance policy he set up with Zurich Life in 2005.
Lobler invested $1.4m in an Isle of Man-based bond. While withdrawing the money, instead of opting to close all the policies or fully surrender a number of individual policies he unknowingly chose to partially surrender across all policies from specific funds – thus incurring a tax bill on nearly all the money he withdrew.
The consultation period closes on 13 July, 2016.
