Many investors may decide to hold their chosen funds in an onshore or offshore investment bond “wrapper”. It has some unique options that make investment withdrawal particularly attractive to certain investors, especially higher rate tax payers who may at some point may want to withdraw up to 5% of their original investment each year, without any immediate income tax liability.
Withdrawing more than your 5%
But what happens if you need to withdraw a larger sum than 5%? The dangers of DIY investment withdrawals are real and can often be costly. All your hard work with fund selection can get seriously eroded if unnecessary tax charges arise from taking withdrawals in the wrong way.
Investment Bonds are often structured as a series of identical policies, or ‘segments’ and there are two options when withdrawing money with hugely different tax results. It’s important to understand these differences and to give clear instructions when requesting withdrawals to avoid “artificial” gains that bear no relation to the actual investment performance achieved.
If withdrawals in the early years are taken as a full surrender of individual segments the tax due is often a fraction of what would be due if the withdrawal was done by partial surrender across the whole policy. That doesn’t mean it will always be the right choice for everyone as it could restrict future income, so it is vital to understand the implications of both.
Choosing the right investment withdrawal option
An example probably best illustrates this.
John, who is a higher rate tax payer, invested £200,000 into an onshore bond just under 4 years ago. This was split into 100 policy segments and has now increased in value to £250,000. There have been no withdrawals so far but he now unexpectedly needs to withdraw a substantial lump sum of £100,000.
Option 1: Take the money equally across all segments
As the bond is in its fourth year he has accumulated 4 lots of unused 5% allowances (i.e. 20%). This means £40,000 can be withdrawn without any immediate tax charge but the remaining £60,000 will trigger a chargeable event. As a higher rate tax payer this could result in a potential tax bill for john of £12,000.
Option 2: Fully encash whole policy segments
As the investment is made up of 100 segments, the initial value of each one was £2,000 and they are now worth £2,500. John cashes in 40 whole segments to raise the £100,000 he needs with a gain of £500 on each. This results in a total chargeable event gain of £20,000 (40 x £500) and, as a higher rate tax payer, reduces the potential tax bill to just £4,000.
The one downside to option 2 is that where whole segments are encashed this will reduce the amount of 5% allowance available in the future as it decreases proportionately depending on the number of segments still available. As John has cashed in 40 segments the 5% allowance would now reduce from £10,000 per annum to £6,000.
No way back if you get it wrong
For some insurers option 1 is the default option so it’s important that you assess both your tax situation and potential income needs before instructing them to proceed with any withdrawal. Unfortunately if the investor has given clear instructions, or the provider has used a default method of withdrawal, HMRC will not allow providers to later ‘undo’ or ‘correct’ this and the chargeable event gain cannot be reversed.
If you are quick and take action in the same tax year then it is sometimes possible to mitigate some of the cost but the easiest solution is to not get caught out in the first place.
If you are unsure on how to proceed then seek professional advice.