Tax on savings and investments Life insurance investments

Profits on life insurance are taxed as income

Certain types of life insurance policies can be used as investments. Lump sum investments into life insurance companies such as with-profit bonds are known as investment bonds or single premium bonds.

Policies where you pay a monthly or annual premium are often known as endowments or investment plans.

Tax liabilities

Income and gains received by UK-based life insurance investments are taxed at 20%, even if you are a non-taxpayer. But you don't pay it yourself – it's deducted from the fund.

Additionally, if you are a higher-rate taxpayer and your policy is ‘non-qualifying’, then you’ll pay an extra 20% income tax on life insurance policy gains when you cash the life insurance policy in or it matures. 

Note, the tax you pay on gains is income tax – not capital gains tax. This is just one of the quirks of the tax system.

Withdrawals

You can withdraw up to 5% (if it's a non-qualifying policy) of the amount you invested in each year before the policy matures, without triggering an immediate higher-rate tax bill. The 5% withdrawals are allowed for a maximum of 20 years. Any tax due is deferred until the year the policy is finally cashed in, or matures.

Qualifying or non-qualifying?

Whether a life insurance policy is qualifying or non-qualifying will determine how it is treated for tax purposes.

Qualifying life insurance policies

Most monthly or annual premium investment policies, such as regular premium endowments, are classed as ‘qualifying policies’. With these you pay no tax on the proceeds when the policy matures – even if you are a higher-rate taxpayer. But this doesn’t mean these investments are tax-free.

Endowments are an example of a qualifying policy

The insurance fund into which your money is invested has paid tax, and this tax can’t be reclaimed.

A qualifying policy becomes a non-qualifying policy if you cash it in or stop the premiums either before 10 years have passed, or before it is three-quarters of the way through the term (whichever comes first).

Non-qualifying policies

Single premium investment bonds are classed as non-qualifying policies and do attract further income tax when you cash them in if you have made a gain and are a higher-rate taxpayer.

Usually the gain from a non-qualifying policy (or a qualifying policy that has become non-qualifying), counts as part of your income for the year you receive it when working out your tax bill. This might count against you if you are eligible for a higher age-related personal allowance.

There is no further basic-rate tax to pay (as this has been deducted from the investment fund) but higher-rate tax could be due at the difference between the higher and basic rate (which is 20% in 2009-2010). However, you might be eligible for ‘top slicing relief’ (see below).

Your policy provider is required to provide a 'chargeable events certificate' including information about what type of policy you have and whether tax is due. 

Top-slicing relief

You don't pay basic-rate tax on the gain from a life insurance policy, because the company has already paid this tax. But, if you are a higher-rate taxpayer, you may have to pay extra tax at the difference between the higher and basic rates (20% or 30% in 2010-2011). 

If adding the gain from a life insurance policy to your income for the year takes you from the basic-rate band into the higher-rate band, you are automatically given ‘top-slicing relief’ if this will reduce the tax due.

The relief bases the tax bill on the average of the gain over the length of time the life insurance policy has run.

Example of top-slicing relief

Suppose in 2010-2011 you have £500 of your basic-rate tax band left and make a gain of £5,000 on a policy that has run for five years. 

Adding the £5,000 to your other income for the year would mean that £4,500 of the gain was taxed, giving an additional tax bill of 20% of £4,500 = £900.

Top-slicing relief would rework the tax bill as described in the following three steps:

• Divide the gain by the policy term: £5,000 divided by 5 = £1,000
  Add £1,000 to your other income for the year and work out tax on the £1,000.
• In our example, half would be covered by the basic-rate band and £500 would be taxed at the higher rate, giving a bill on the £1,000 slice of 20% of £500 = £100.
• Multiply the tax on the £500 slice by the policy term to find the final tax bill. £100 x 5 = £500.

Top-slicing relief has therefore reduced the £900 tax bill by £400.

The tax rules change once you stop working

Age-allowance and life insurance policies

If you are over 65 or 75, you are entitled to a higher personal allowance than taxpayers under 65. For 2010-2011, people aged 65 to 74 can receive £9,490 income during the year before paying tax, and those 75 and over can receive £9,640.

However, in order to qualify for the full allowance, your income must not exceed a certain limit – £22,900 for the tax year beginning 6 April 2010.

Income over the limit

If you have income above this limit, your higher allowance will gradually be withdrawn at the rate of £1 for every £2 that your income exceeds £22,900, until it’s reduced back down to the basic personal allowance (£6,475 in 2010-2011).

So, for example, a 65 year-old with a total income of £24,000 (£1,100 over the limit) will lose half of this (£550) from the higher allowance, bringing it down to £8,850.

Gains from life insurance policies can have a drastic effect if you are claiming the higher age-related personal allowance, as the gain is added to your other income for that tax year and may wipe out any higher age-related allowance you are entitled to.

For example, if your income is £20,000, but you have a gain of £10,000, your total income for this tax year would increase to £30,000 and you would be over the limit for any higher allowance. You won’t have to pay additional tax on the gain (as you are still in the basic-rate tax band), but you will pay more tax on your other income.

So, if you will be 65 or over when cashing in a life insurance investment bond, you need to be aware of the impact this might have on your tax situation.

For further information on how tax changes with age, see our guide to tax and allowances for older people.

Paying more tax with life insurance investments

The 18% rate for capital gains tax (CGT) means that most people, particularly higher-rate taxpayers, will pay more tax on a non-qualifying life insurance investment (such as an investment bond) than, for example, a unit trust.

When you cash in a unit trust it can potentially be liable for CGT, but often gains fall within the annual CGT exemption (£10,100 for 2009-2010) so no tax is due.

However, even if CGT is due, it will now be at the rate of 18%, compared with 40% or 50% income tax paid by a higher-rate taxpayer on an investment bond (20% paid by the life insurance company and 20% or 30%by the taxpayer).

If your financial adviser recommends an insurance bond as an investment, make sure they have taken the tax position fully into account, and ask them why this is better for you than, say, a unit trust or Oeic.

Chartered Institute of Taxation

Which? is grateful for assistance from the Chartered Institute of Taxation in compiling this guide. For details of the Institute and its work, see www.tax.org.uk