This is a popular investment product in the financial adviser’s armoury, particularly for the unsophisticated investor. They require little administration and, until they are cashed in, they do not produce taxable income or capital gains in the hands of the investor and do not trigger an obligation to file a tax return for a taxpayer who otherwise would not need to file one.
The rules enable cash withdrawals of 5% of the amount of the original premium to be drawn from the policy each year for up to 20 years without incurring an income tax liability. Even when this limit is exceeded, any ‘chargeable event gain’ is treated as having borne basic rate tax at source, and a basic-rate taxpayer would not have any tax to pay (this does not apply to offshore bonds). It is also possible to have the policies written in trust, so they do not form part of the taxable estate at the date of death.
The common pitfall
These policies can often be an issue for executors of a will. Executors often fall into the trap of believing that there are no tax liabilities arising on these investments. After all, if the policy is written in trust and capital gains are not charged on death, what could go wrong?
Unfortunately, life policies are not within the Capital Gains Tax (CTG) regime. Any gain within the policy, even if it has not been cashed in, is subject to income tax and the rules do not provide an exemption when the life assured dies, unlike with CGT.
Usually, the result is that the chargeable event gain is assessed on the deceased in the year of their death. If a policy has been in existence for many years, this could result in a substantial gain, which is charged to income tax in the tax year in which the taxpayer dies. This may be enough to land the executors with a substantial higher-rate income tax liability.
What to do about it
Fortunately, there is a relief which may help, known as ‘top-slicing relief’. In the simplest case the effect of the relief is to treat the gain as if it arose evenly over the period the bond was held, and the tax position is calculated without the ‘bunching’ effect. This can substantially reduce, or even eliminate the higher rate tax charge altogether.
This is a highly-simplified statement of the position. In practice, depending on the taxpayer’s other income and the details of any previous partial encashment, the calculations can be complex. If you find yourself as an executor holding such a bond you should seek professional advice to ensure you do not fall foul of any common issues.