How does the 5% annual withdrawal allowance from an offshore bond work?

Full answer

Offshore investment bonds are life insurance contracts issued outside the UK. They have a unique tax treatment under the "chargeable event" regime, which includes the 5% allowance -- one of their most misunderstood features. The 5% cumulative allowance Each policy year, the policyholder can withdraw up to 5% of the original premium invested without triggering an immediate income tax charge. Unused allowance accumulates: if nothing is withdrawn in year 1, year 2 allows up to 10% withdrawal, and so on. This continues for up to 20 years (when the cumulative allowance is fully used at 100%). Critically, this is a deferral mechanism, not an exemption. The deferred gain eventually comes into charge -- either on encashment, maturity, death of the life assured, or partial surrender exceeding the cumulative allowance. Chargeable event gain When a chargeable event occurs, HMRC calculates a "chargeable event gain" -- broadly, the profit on the bond. This gain is assessed as income in the year of the chargeable event, potentially pushing the policyholder into a higher tax band. Top-slicing relief Top-slicing relief (TSR) is designed to mitigate the bunching of deferred income into a single year. The gain is divided by the number of complete policy years to create a "slice." The slice is added to other income to determine the marginal tax rate applicable, which is then applied to the whole gain -- not the single-year rate that would result from adding the entire gain to income in one year. Assignment strategy A gain on an offshore bond is taxed on the person who receives the money (the assignee). Assigning a bond to a lower-rate taxpayer (e.g., an adult child, spouse in lower rate band) before encashment can substantially reduce the tax bill. Comparison with onshore bonds Onshore bonds carry a 20% notional tax credit (the insurer pays corporation tax), meaning basic-rate taxpayers usually have no further liability on encashment. Offshore bonds have no such credit, making top-slicing planning more important.