Module 6 – How to work out the gain using the 5% rule
What is the 5% rule?Welcome to module 6 – how to work out the gain using the 5% rule.
The 5% rule is a special rule which only applies to partial withdrawals across all segments.
The rule operates so that partial withdrawals of up to 5% a year of accumulated premiums can be made with any tax charge postponed.
In some cases, the 5% rule becomes an exemption if the policyholder’s circumstances have changed so that by the time the deferred tax charge is triggered there’s no tax payable.
Let’s see how this works in practice…
Every policy year there’s an allowance of 5% of the premium paid – maximum 20 years.
Any unused allowance can be carried forward until the bond comes to an end. The policyholder can carry forward unused allowances from year to year, so they may have the opportunity to withdraw more than 5% without having to pay tax.
Example:
Year 1 – 5% allowance
Year 2 – 5% allowance
Year 3 – 5% allowance
to
Year 8 – 5% allowance
In year 8, no previous withdrawals have been made so there is a cumulative allowance of 8 x 5% of the premiums paid.
Here’s an example:
Mr Bryce takes out an onshore bond of £100,000.
The 5% rule can be applied to the bond in each policy year. If, however, Mr Bryce doesn’t take a withdrawal in that year then his 5% entitlement carries into the next year.
By year 4, Mr Bryce hasn’t taken a withdrawal from the bond and so has carried the 5% allowance over four years = £20,000 (5% of £100,000 is £5,000 a year). He withdraws £8,000 in year 4 and, since this amount falls within his cumulative 5% allowance of £20,000, he has no tax immediately due. Withdrawals over the cumulative allowance are excesses and are treated as a gain.
The remaining 5% allowance after this withdrawal is £20,000 - £8,000 = £12,000, which can be carried forward into the following year of the policy.
Below is an example of how the 5% allowance works. This case incorporates premium increases, withdrawals under the 5% limit, withdrawals over the 5% limit and also no withdrawals in a particular year.
Let’s have a look at each stage of the bond.
Year 1
In year 1, £100,000 is paid into the bond. £3,000 is taken out in that same year. There’s a 5% allowance a year. 5% of £100,000 = £5,000. Therefore, the £3,000 can be withdrawn without being a chargeable gain and £2,000 is carried over to the following year.
Year 2
In year 2 a withdrawal of £10,000 is taken. There’s a 5% allowance of £5,000 + the £2,000 allowance carried forward from year 1 = £7,000. Therefore, £3,000 becomes a chargeable gain (£10,000 - £7,000). There’s no carried forward allowance.
Year 3
In year 3, a further £50,000 is added to the bond. The 5% allowance for that year is 5% of £150,000 = £7,500. No withdrawals are taken, the 5% allowance of £7,500 carries forward to the next year.
Year 4
In year 4, a withdrawal of £6,000 is made and there’s a cumulative allowance of £15,000 (5% allowance of £7,500 and the £7,500 allowance carried forward from year 3), There’s no chargeable gain on the withdrawal and an allowance of £9,000 (£15,000 – £6,000 = £9,000) carried over to the following year.
Year 5
In year 5, a further £50,000 is added to the bond (£200,000). 5% of £200,000 is £10,000 + allowance carried forward is £9,000, so the total allowance is £19,000. A withdrawal of £25,000 is taken out and the chargeable gain is £25,000 - £19,000 = £6,000. There’s no carried forward allowance.
To which of the following chargeable events can the 5% rule be applied? You can find the answer at the end of this module.
Option 1 – Total surrender of the policy
Option 2 – Surrender of individual segments
Option 3 – Death of a life assured
Option 4 – Partial withdrawals across all segments
The allowance on partial withdrawals
In this section you’ve seen how to apply the 5% allowance on a chargeable event that arises from a partial withdrawal across all segments.
Answers to questions in module 6
Question 1
To which of the following chargeable events can the 5% rule be applied?
Option 1 – Total surrender of the policy
Option 2 – Surrender of individual segments
Option 3 – Death of a life assured
Option 4 – Partial withdrawals across all segments
Answer
The correct answer is option 4. The 5% rule is only applicable to partial withdrawals across all segments. It can’t be applied to gains from any other chargeable event.