The 5% allowance

Withdraw up to 5% a year with no immediate tax — and understand what 'immediate' is doing in that sentence.

You can take up to 5% of what you originally invested out of a bond each policy year without an immediate tax charge. It's the feature bonds are best known for, and it's routinely misunderstood in a way that costs people money later.

How it works

Each policy year you accrue an allowance of 5% of each premium paid. Take less than that and the unused part carries forward. Take more and the excess becomes a chargeable gain straight away.

It's cumulative. Take nothing for four years and you have 20% available in year five.

It runs for a maximum of 20 years per premium. Five per cent for twenty years is 100% of what you put in, and at that point the allowance is exhausted. There's no further allowance after that, however long you hold the bond.

It's based on the premium, not the value. A £100,000 bond now worth £180,000 still has an annual allowance of £5,000, not £9,000.

Policy years, not tax years. The clock runs from the policy start date. A bond taken out in September has policy years running September to September, and a withdrawal in the wrong week can land in a different policy year from the one you intended.

What "no immediate tax" really means

This is the part people miss.

Withdrawals inside the 5% allowance are not tax-free. They are tax-deferred.

Every pound you take out under the allowance is added back when the final gain is worked out on full surrender. The formula counts the surrender value plus everything you have ever withdrawn, less the premiums paid and any gains already taxed.

So a bondholder who took 5% a year for fifteen years hasn't avoided tax on that money. They've postponed it, and it arrives in a single lump on the day the bond is finally cashed in.

That isn't necessarily bad. Deferring a charge from your working life into retirement, when your rate may be lower, is often exactly the point. But it should be a plan rather than a surprise, and a great many people are surprised.

The excess event

Take more than your accumulated allowance in a policy year and the excess is a chargeable gain immediately, in that tax year.

Two features make this dangerous:

The gain has nothing to do with profit. It's calculated as the amount withdrawn less the unused allowance, regardless of whether the bond has grown at all. A bond that has lost money can still produce a taxable gain on a large withdrawal.
It's charged as income, not capital gain. It sits on top of everything else you earn, at your marginal rate, with no annual exempt amount to shelter it.

This is the mechanism behind the classic and expensive mistake set out in Taking money out of a bond.

Keep track of it

Most insurers will tell you your remaining allowance if you ask, and many show it on the annual statement. You want to know:

The original premium, and the date of any additional premiums
How many policy years have elapsed
Total withdrawals taken to date
Any chargeable gains already reported

Without those figures you can't tell whether a withdrawal will trigger a charge, and the Bond Encashment Calculator needs them too.

If a bond has been held for a long time and the paperwork has gone, request a chargeable event history from the provider before taking anything out. It takes a few weeks and it's considerably better than finding out afterwards.

The twenty-year cliff

Worth planning for. Once the allowance is exhausted, every further withdrawal is a chargeable gain in the year it's taken.

Someone who has been drawing 5% a year as income for two decades reaches a point where the same withdrawal suddenly becomes taxable, with no change in their behaviour. If a bond is funding regular income, that date should be in the diary well in advance.

This article is for general education only and isn't personal advice. Chargeable event calculations depend on the full history of a policy.