Q: I am considering surrendering a life insurance policy. What tax implications should I be aware of?
A: The tax treatment will depend on the type of policy – the policy will be either a qualifying or non-qualifying one. If you are unsure what type it is, a financial adviser should be able to let you know.
Where a qualifying policy is allowed to mature, the proceeds are tax-free. However, if a qualifying policy is surrendered, varied or assigned less than ten years after the policy is taken out, any profit may be taxable depending on the level of tax you usually pay.
The proceeds arising from a non-qualifying policy are not wholly tax-free. As long as they are received by the original policyholder they are free of capital gains tax, but the capital appreciation is again taxed as income.
A non-qualifying policy often takes the form of a single premium investment bond. It is possible to make withdrawals of not more than a cumulative 5 per cent of the initial investment in each policy year without attracting a tax liability. As the 5 per cent is cumulative, any unused amounts can help in a later year when a larger withdrawal is made. If more than 5 per cent is taken out, the excess is chargeable to tax. These withdrawals are taken into account when calculating the profit when the bond is cashed in.
UK insurers are required by law to issue a certificate if they know a gain has been made, this is known as a chargeable event gain certificate.
Although the ‘profit’ for each type of policy is often referred to as gains, they are not capital gains so the annual exemption and capital losses cannot be set against them. Instead they are taxed as income and added to your other income. Basic rate tax at 20 per cent is deemed to have been paid and so only extra tax will be due if you are a higher-rate tax payer. If this extra income takes you into the higher-rate tax bracket then top-slicing relief is available, which will lessen the tax impact.
If the gain is on a foreign policy there is no deemed payment of basic rate tax.
Care needs to be taken when deciding in which year a gain is taxable. If the gain is made when the policy comes to an end due to death or the maturity, sale or surrender of the whole policy it is simply the tax year that event falls in. However, if there is a partial surrender or sale, then it is the tax year in which the last day of the policy’s insurance year falls. An insurance year is usually the 12-month period from when the policy is taken out.
More detailed information can be found at hmrc.gov.uk/helpsheets/hs320.pdf