The 5% allowance trap: a taxable gain on a bond that lost money

Each policy year, a bond holder may withdraw up to 5% of the premiums paid without an immediate tax charge. Unused allowance rolls forward, and the pool caps at 100% of premiums (twenty years of unused 5%s). The trap is in what the allowance is: a deferral mechanism measured against premiums, not a measure of profit. A part surrender above the cumulative allowance creates a chargeable event gain equal to the excess — whatever the bond has actually done.

A losing bond that produces a tax bill

An offshore bond: £100,000 single premium, three complete policy years, nothing withdrawn so far, current value £95,000 — the investment is down £5,000. The client asks for £30,000. The cumulative allowance is 3 × 5% × £100,000 = £15,000. A part surrender of £30,000 exceeds it by £15,000, and that excess is a chargeable event gain in the year.

A £2,400 income-tax bill on an investment that has lost £5,000. Nothing has gone wrong in the computation — this is the part-surrender rule working exactly as designed, measuring the withdrawal against the allowance rather than against growth.

IPTM3540 · IPTM3560 · ITTOIA 2005 s.507 — figures engine-computed, 2026/27 config

The knock-ons people miss

The artificial gain is real income for every test that keys off income: it counts toward adjusted net income for the £100,000 personal-allowance taper, toward the High Income Child Benefit Charge, and toward the PSA banding. A “tax-free 5% withdrawal” framing also misleads in the other direction — within the allowance nothing is tax-free, only deferred; every deferred amount washes through the final surrender computation.

The common error, and the way out

The error is treating the 5% allowance as the only way to get money out. The same £30,000 taken by surrendering whole segmentsproduces a gain measured on actual performance — on this bond, no gain at all (the engine's segment route raises £30,400 from 32 of 100 segments with £0 tax). The mechanics of that comparison are the subject of part surrender vs segment surrender, and you can price all three routes on your own figures with the chargeable event gain calculator. The decision must be made — and instructed — before the provider pays the money out; an excess event, once triggered, cannot be re-routed.

For genuinely disproportionate outcomes, ITTOIA 2005 s.507A (rectification on application) exists — narrow, post-2017, and no substitute for choosing the right route first.