Taxation of Partial withdrawals

For partial withdrawals, the gain is determined at the end of each policy year, when all withdrawals are added together. The 5% rule still applies so up to 5% of the original investment may be withdrawn each policy year without attracting an immediate tax liability. The potential tax liability is deferred until encashment or death.

Provided that the withdrawals do not exceed 5% or the cumulative allowance (5% for the current year plus any unused allowance carried forward from previous years), then there will be no immediate potential tax liability.

Upon encashment a sweeping up process needs to take place in order to account for all partial withdrawals and to arrive at the true chargeable gain.

Example

Original investment £10,000

Year 1

Part surrender of £500 – no immediate tax liability as this is 5% of the original investment.

Year 2

Part surrender of £1,000 – a chargeable event occurs because the accumulated withdrawals (£500 + £1,000) exceed the total of 5% of the original investment per year. The chargeable gain is therefore £1,500 – (2 x £500) = £500. If the investor is a higher rate taxpayer they will have to pay a further £100 in tax (40%-20% x £500)

Year 5

The Investment Bond is encashed for £15,000. 

Encashment value	£15,000
Plus part surrender 1	£15,500
Plus part surrender 2	£16,500
Less original investment	£10,000
Less previous chargeable gain	£500
Chargeable gain	£6,000

The final chargeable gain at encashment of £6,000 is subject to top-slicing in the usual way. Making partial withdrawals from an Investment Bond does not alter the total chargeable gains that may arise; however, it can alter when any gains will be assessed to tax.

Age allowance for the over 65s

Withdrawals from Investment Bonds that are within the 5% rule are not treated as income and are not added to the individual‘s income for age allowance purposes. Any withdrawals in excess of the 5% rule will be treated as income in that tax year and, therefore, may affect age allowance calculations.