Segmentation is a fairly standard feature on single-premium insurance contracts that provides extra flexibility in how capital is withdrawn from the contract. However, it is sometimes overlooked that segmentation can also be an attractive feature on regular premium policies.
Segmentation refers to an investment bond or savings plan in which, instead of premiums being allocated to one policy, they are split between a number of smaller, independent policies. In relation to a regular premium contract, each premium would be divided equally between each individual policy (see figure 1).
A bigger slice of the pie
There are several benefits associated with segmentation. If gifts are contemplated, for example, to a spouse or child attending university, segmentation can offer the investor the option to assign individual policies to the recipient, rather than to the whole arrangement.
The recipient can then make encashments and, if tax is due on the gains, the recipient will bear the tax liability.
The benefits of segmentation are most commonly realised when the policyholder begins to draw on the policy. Where the policyholder wishes to draw money from the policy, there are several ways in which they can do so:
(i) Take a withdrawal. If the policy is segmented, then the withdrawal will usually be split evenly across all policies.
(ii) Surrender the whole plan.
(iii) If the plan is segmented, surrender individual policies in the plan, leaving the remainder in force.
If a policyholder is UK-resident, taking a withdrawal, as per (i) above, will initially be covered by any unused 5% withdrawal allowance. This well known feature deems 5% of the premium each year to be a return of capital, which is tax deferred.
If the total allowance is not used in one year, it can be carried forward to the next and subsequent years. On a single premium policy, calculation of the withdrawal is relatively straightforward, but how does it work on regular premium policies?
First, any withdrawals taken during a policy year are deemed to have been made on the final day of the policy year. These are then matched against any accumulated withdrawal allowances, including the allowance on any premium paid during the policy year.
In other words, each annualised premium is treated as a single premium for the purposes of working out the 5% withdrawal allowance.
Emma sets up her savings plan on 1 January 2011 and saves £1,000 per month. She returns to live in the UK permanently on 1 June 2015 and she asks her adviser how much she could withdraw without incurring any tax liability. Providing Emma pays all premiums due in 2015, her allowance would be calculated as seen in figure 2.
If Emma needs £9,000 or less, a withdrawal across all policies creates no immediate charge to UK tax. However, if she needs more than £9,000, the excess will be taxable. In certain circumstances, taking a large withdrawal will be a very inefficient way of drawing capital from the policy.
This is because the calculation of the excess withdrawal does not take into account the economic performance of the policy. This can create an artificial gain and, in these circumstances, it may be better to draw on the policy via the surrender of individual policies. Figure 3 illustrates this.
It is clearly much more tax-efficient to take the money by way of individual segment surrender. If Emma had chosen the provider that does not offer a segmented policy, she would have had no choice but to either take the money by way of a tax inefficient withdrawal, or to wind up the policy in total – incurring tax on the whole gain.
Neither option would be attractive, leading to an unhappy customer and possibly a complaint directed at the adviser.
Emma’s savings plan commenced when she was resident in Singapore. Therefore, she could have opted to take her money while resident there, and incur no tax on the proceeds at all.
However, there is a trap. If capital is taken by way of withdrawal, the withdrawal is deemed to occur on the final day of the policy year, by which time the policyholder could be UK-resident. This trap can result in an unexpected tax charge – and resulting complaint to the adviser. Saving via a segmented plan can help (see figure 4).
This illustrates how the benefits of policy segmentation can also apply in the context of regular premium policies. You never know when a client may need to avail of this important feature, so choosing a provider who can offer this at outset ensures flexibility is available if needed.