Life Insurance and Tax Implications

There are generally two types of life insurance products: one that pays out a sum of money to a beneficiary upon death, and another that functions as an investment vehicle, providing returns similar to other savings products.

For tax purposes, these life insurance policies fall into two categories: qualifying and non-qualifying.

Qualifying Policies

Qualifying policies are long-term contracts where regular premiums are paid, typically with little variation in the annual premium amounts. These policies usually offer a relatively high sum assured compared to the premiums paid. Importantly, no tax charge arises when a qualifying policy matures, unless the policy is cancelled early.

Non-Qualifying Policies

Non-qualifying policies, in contrast, are typically funded by a single premium rather than regular contributions, and they are more akin to an investment vehicle. Many of these policies are known as single premium insurance bonds.

In these policies, the investor pays a lump sum initially and later cashes in the policy, often at a significant profit. Upon maturity, non-qualifying policies are subject to taxation under life insurance gains.

Tax Implications for the Policyholder

When a non-qualifying policy is cashed in, it triggers a chargeable event, which is subject to income tax on any gains. These chargeable event gains are considered savings income, and as such, the policyholder may benefit from the savings allowance.

Non-qualifying policies are deemed to carry a notional 20% tax credit. This credit can reduce the income tax liability to zero, but it cannot result in a tax refund. The implications are as follows:

Higher or additional rate taxpayers: These individuals may still be liable for additional tax on event gains if they were higher or additional rate taxpayers prior to the chargeable event.
Basic rate taxpayers: The notional tax credit typically covers the liability, meaning no additional tax is due.
Change in tax status: If the event gain causes a basic rate taxpayer to become a higher or additional rate taxpayer, top slicing relief may apply, reducing the tax liability.

Top Slicing Relief

Top slicing relief allows for the chargeable event to be sliced to reflect the number of years the life policy gain has been earned over . The steps to calculate top slicing relief are as follows:

Divide the gain by the number of complete years the policy was in force. This gives the “top slice.”
Add the top slice to the taxpayer’s other income in the year, calculating the additional tax due on that slice.
Deduct the notional 20% tax credit from the top slice to determine the “net” tax on the slice.
Multiply the result from step 3 by the number of complete years the policy was held. This gives the relieved tax on the policy gain.
The relief is provided as a deduction from the tax payable, representing the difference between the tax on the total policy gain and the relieved tax liability.

Partial Surrender

A policyholder may choose to partially surrender their policy without triggering an income tax charge, as long as the surrender does not exceed 5% of the initial investment per policy year.

This 5% limit is cumulative. For example, after three policy years, up to 15% of the initial investment can be withdrawn tax-free.