Tick the right boxes when surrendering insurance policies to avoid tax

Insurance policies can be a minefield when it comes to tax. We have blogged about this in the past when we have come across unexpected tax liabilities which have resulted in reduced pay outs on key man insurance.

There have been a series of cases recently which draw attention to this issue again, albeit in a slightly different way. In each case, taxpayers had created a large tax liability for themselves through not taking into account the implications of the way in which they withdrew their funds.Most people expect to pay tax when there has been a gain of some sort – from an investment, insurance policy or following the sale of assets. In some cases however cashing in an investment policy can generate a large tax liability, even if it does not also generate a gain.

In general terms a life policy can be divided into a number of smaller, identical policies. When a withdrawal is made, the investor is given a choice as to how he would like to structure that withdrawal; as a partial surrender of all the policies, or as a full surrender of a number of individual policies.  If the investor requests a “partial surrender across all policies from specific funds”, the result is that the money withdrawn is treated as taxable income to the extent that it exceeds 5% per annum of the original premium. Income tax is then payable on this excess.

Although this may seem a very unfair outcome, it arises because of the overly complex tax legislation on life assurance policies.  The example below highlights how tax is calculated on ‘gains’ from insurance policies.

Mrs X invested £200,000 in a group of 20 insurance policies through an overseas life insurance company. After 12 months she wanted to withdraw £50,000 and ticked a box on the administration form requesting a partial surrender across all 20 of the policies. Wrongly, she believed that because no profits had been made on the investment, taking out the £50,000 in this way would not incur a tax liability. It was a shock to be notified that tax was actually payable. This is calculated as follows:

[one_half]Partial surrender value
Less:  5% of original premium (1 year) £200,000 x 5%
Chargeable gain[/one_half] [one_half_last]£50,000
(10,000)
£40,000[/one_half_last]

By contrast, if Mrs X had surrendered the whole of around one quarter of the policies, she would still have received £50,000, but no income tax would have been chargeable as there would have been no gains on the surrender of each of the policies.

Our advice to clients is to be very careful when making withdrawals from investments containing life insurance policies. Always seek financial advice and obtain professional advice on the tax implications before making investment decisions or withdrawals; even if you do not make a gain in the traditional sense from cashing in a policy, you could be creating a tax liability purely by the decisions you make when completing the form.

For more information contact Lesley Stalker.