What it means
You pay a lump sum to the insurer, which invests it in funds you select, such as shares, bonds or property. The policy includes a small amount of life cover, and that is what makes it an insurance policy for legal and tax purposes.
The tax treatment depends on the country, so the rules must be checked locally. In the United Kingdom, for example, growth inside the bond is taxed within the insurer, and the holder can usually take up to 5% of the original investment each year without an immediate tax charge.
The 5% allowance is cumulative in that system, meaning unused allowance can be carried forward. Withdrawals above the allowance, and the final gain when the bond ends, can lead to tax, calculated using a special method that spreads the gain over the years held.
Insurance bonds are used in estate planning because they can be placed in trust, and for people who want to defer tax or invest across borders. Some are offered offshore, which adds further rules on reporting and taxation.
The downsides are costs and complexity. There are often higher charges than for a simple fund, and surrender penalties may apply if you cash in during the first few years.
They are not suitable for everyone, and the benefits depend on the investor's tax rate now and in the future. A qualified adviser should explain how the bond would be taxed in the investor's country before any money is committed.
In practice
Real-world examples.
Example
A retired manager invests $300,000 from a house sale into an insurance bond and takes 5% a year, or $15,000, as extra income. The withdrawals are treated as a return of capital under the local rules and no tax is due at the time. After twenty years the 5% allowance would have returned the entire original sum.
Example
A business owner with a high tax rate puts a surplus into a bond and plans to cash it in after retirement. She hopes that her tax rate will be lower then, so the gain will be taxed less. Her adviser reminds her that tax rules can change, so the benefit is not guaranteed.
Example
A grandparent places an insurance bond in trust for a grandchild. The trust holds the bond, and the planner explains how future gains will be taxed when the bond is passed on or cashed in. The grandparent also names who should receive the money if the grandchild is too young to manage it.
Formula
Calculation
Annual tax-deferred withdrawal allowance = Original premium x 5%, with unused allowance carried forward (in systems that allow this)
An investor puts $100,000 into an insurance bond. The annual allowance is 100,000 x 5% = $5,000. If she takes nothing in years 1 to 3, the cumulative allowance after three years is 3 x 5,000 = $15,000. She could withdraw $15,000 in year 4, plus that year's own allowance of $5,000, without an immediate charge, a total of $20,000.Case study
Seen in the real world.
Whitmore Advisory is an illustrative, fictional firm that advised a client, Raj, with $400,000 to invest. He wanted to draw income but was in a high tax bracket while working, and expected a lower bracket after retirement.
The adviser proposed an insurance bond in which Raj would take no withdrawals for five years and then cash in during retirement. In the meantime the investment grew inside the bond, and the adviser showed Raj the charges, which were 0.5% a year higher than a plain fund. On $400,000 that extra cost is 400,000 x 0.005 = $2,000 a year, so the tax saving had to be larger than that to be worthwhile.
The fictional client chose the bond for the tax planning benefit and accepted the higher cost. The illustrative lesson is that a wrapper like this only pays off if the tax advantage exceeds the extra charges. Raj's adviser also noted that if his plans changed and he cashed in early, a surrender penalty would apply.
Watch out
Common mistakes.
- Thinking an insurance bond is a bond in the debt market sense, when it is an insurance policy that invests in funds.
- Ignoring the charges and surrender penalties, which can reduce the benefit of any tax deferral or even cancel it completely.
- Assuming the tax treatment is the same everywhere, when rules differ widely between countries and change over time.
Questions
People also ask.
What is the 5% rule?
In some jurisdictions the holder can withdraw up to 5% of the original investment each year without an immediate tax charge, with the allowance carrying forward if unused. The tax is only deferred, and a charge may arise when the bond is finally cashed in.
Can I lose money in an insurance bond?
Yes, because the money is invested in funds whose value can fall as well as rise. The insurer may also charge fees that reduce the value even when the funds do not fall.
Who should consider an insurance bond?
People who have used other tax allowances, who want estate planning flexibility, or who expect to be in a lower tax bracket later may consider one, after taking advice.
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