The 5% withdrawal allowance: tax-deferred, not tax-free

How the 5% allowance works

A withdrawal that does not end the policy is a part surrender. Part surrenders are not measured one by one. At the end of each insurance year the insurer compares everything you have taken out so far with an allowance built up from your premiums (ITTOIA 2005 s.507; IPTM3560). HMRC describes the allowable element of each premium as “the amount of the payment multiplied by y/20, where 'y' is the number of insurance years, not exceeding 20”.

In working terms the rule has four parts.

• 5% of each premium per insurance year. On a £2,000,000 single premium, £100,000 a year.
• Cumulative. Allowance you do not use carries forward. Take nothing for five years and you can take up to £600,000 in year six without an immediate charge: the allowance counts the current insurance year, so it is 6/20 of £2,000,000 (ITTOIA 2005 s.507). HS321 describes the allowance as the “unused one twentieth of the premiums paid in the year and each previous year”.
• Capped at 100%. The allowance on each premium stops after 20 insurance years: HS321 notes the maximum “will be reached if 5% of the premiums are taken for 20 consecutive years”.
• Per premium. A later top-up premium starts its own 20-year clock from the insurance year in which it is paid.

An insurance year runs from the date the policy was taken out to the day before the anniversary (IPTM3505). It is not the tax year, and that difference catches people out when they time a withdrawal.

The allowance does not depend on performance. You can take 5% from a bond that has fallen in value. You are then drawing down your own capital, and the tax result at the end will reflect that.

Tax-deferred, not tax-free

HMRC's helpsheet calls it the “5% tax deferred allowance” (HS320). A withdrawal inside the allowance is not a chargeable event, is not taxed in the year you take it and does not go on your return. But when the policy finally ends, the gain is the total of everything paid out over its life, including every one of those withdrawals, less the premiums and less any gains already taxed (s.491; IPTM3500).

The bond paid £100,000 a year for twenty years with no tax at the time, and every pound of growth was still taxed in the end, as income at the holder's rate in the year of surrender. The allowance bought time. The holder had twenty years of cash flow with no tax charge, in exchange for a single charge later, when the holder may pay a lower rate, may no longer be UK resident, or may have given segments to family members. How the final gain is taxed and how top-slicing relief applies to it is in chargeable event gains and top-slicing relief.

Two points are often missed. Calling the withdrawals “5% income” is misleading for tax: they are not income, they do not use your savings allowance and they do not appear on your return, because for tax purposes they are a return of premium until the policy ends. And once the 20 years of allowance on a premium are used up, there is nothing left to defer. From year 21 every part surrender of that premium is an excess in full.

Excess events: what happens when you take too much

If, at the end of an insurance year, the total you have taken out exceeds the total allowance, the difference is a chargeable event gain (s.507; s.509 treats it as an excess event). The rule is harsh.

• It ignores growth. The excess is measured against premiums, not against how much the bond has made. A bond that has grown by £40,000 can produce an £800,000 gain.
• It arises at the end of the insurance year. HMRC's example is a part surrender on 1 April 2020 in an insurance year ending 31 May 2020, which is assessed in 2020/21, not 2019/20 (IPTM3505).
• It is taxed like any other bond gain. Savings income at 20, 40 or 45% in 2026/27 (22, 42 or 47% from 6 April 2027), with no basic-rate credit on an offshore policy. Top-slicing relief applies to individuals. HMRC's manual says that for an offshore bond the years for the slice run back to the start of the policy if it was issued before 6 April 2013 or time apportionment applies; for a later policy held by someone who has always been UK resident, they run from the previous excess if there was one (IPTM3830). Insurers' technical guidance, including M&G's, also covers this point.

An excess resets the running total. HMRC's worked example in IPTM7620 shows how, and also how a top-up premium adds its own allowance.

The year 5 excess used up the allowance to date, so in year 7 only the new allowance (£1,500) was set against the new withdrawals (£3,000). Both gains, £2,750 in total, are deducted when the final gain is worked out, so they are not taxed twice.

Segments: two ways to take the same cash

Offshore bonds are normally issued as a cluster of identical policies, called segments, often a hundred or more. Each segment is a separate policy for these rules. That gives you two different ways to take a large sum. You can part surrender across every segment, which is measured against the 5% allowance. Or you can fully surrender some whole segments, each of which is a final event with its own gain of value less premium. Insurers' technical guidance, including M&G's, describes the choice and notes that the 5% allowance applies segment by segment. The difference can be very large.

Hypothetical. A UK resident with £150,000 of other income paid £2,000,000 into an offshore bond issued as 100 segments of £20,000. He has taken nothing. At the end of the second insurance year the bond is worth £2,040,000, so each segment is worth £20,400. He needs £1,000,000.

Carry both forward three years, with the remaining investments growing by the same 10.58%. In A the remaining bond is worth £1,150,000 at the end of year 5. On full surrender the gain is £1,000,000 + £1,150,000 minus £2,000,000 minus the £800,000 already taxed, which is minus £650,000. The bond made £150,000 over its life, the holder was taxed on £800,000, and the negative figure can be used only through deficiency relief, which does not reduce tax at the additional rate (IPTM3880). In B the remaining 50 segments are worth £1,127,885. The gain is £1,127,885 minus £1,000,000, which is £127,885. Over the two events B is taxed on £147,885, which is exactly what the bond made.

The two routes can be combined. Taking the 5% across all segments first and surrendering whole segments for the rest gives a result close to B, because what remains after the 5% is surrendered at its own value less premium. What matters is deciding before the instruction goes to the insurer. Once a part surrender has been paid, the gain for that insurance year is fixed by the arithmetic, and the only route back is the application described next.

When the gain is wholly disproportionate: ss.507A and 512A

The law allows a person liable on a part-surrender gain that is wholly disproportionate to ask HMRC to recalculate it (ITTOIA 2005 s.507A for part surrenders, s.512A for part assignments). HMRC's guidance is in IPTM3596:

• Who applies. The “interested persons”, meaning those liable to tax on the gain. Where there is more than one, all of them must apply together, for example joint policyholders.
• Time limit. The application “must be received by HMRC within four years of the end of the tax year in which the gain arose”. Remember that an excess gain arises at the end of the insurance year, which fixes the tax year.
• What HMRC looks at. Factors include “the economic gain on the rights surrendered or assigned” and “the amount of the premiums surrendered in relation to the premiums paid”. The guidance makes clear that being out of proportion to the economic gain is not enough on its own; the gain must be wholly disproportionate.
• The result. A qualifying gain is “recalculated by an officer of HMRC on a 'just and reasonable' basis”, usually by reference to the underlying economic gain, and the recalculation will not produce a larger gain than the original.

In route A, £800,000 was taxed against £40,000 of growth, which is the kind of figure an application would put before HMRC. The decision is HMRC's, though, and the threshold is high. Treat the application as a remedy for a mistake that has already happened; choosing route B at the outset costs nothing.

Using the allowance well

• Plan withdrawals against insurance years, not tax years. The measurement date is the policy anniversary. A withdrawal in March and another in May can fall into the same insurance year and the same test.
• Take large sums by whole segments. Anything above the cumulative allowance should normally come from full surrender of segments, as route B shows.
• Keep the 20-year horizon in view. Taking the full 5% every year uses the allowance in 20 years. After that, every part surrender is fully taxable, so a family that needs income for longer may take less each year.
• Top-ups have their own clock. Each new premium adds 5% a year for 20 years from the insurance year it is paid.
• Trusts. Where a bond sits in a loan trust, the trustees may use withdrawals within the allowance to repay the settlor's loan. How that interacts with inheritance tax is covered in loan trusts and discounted gift trusts.
• Moving country. Withdrawals inside the allowance are not events, so they create nothing to tax wherever you live. A final gain taken while non-UK resident is outside UK income tax unless you return within five years. See moving to, returning to or leaving the UK.
• A personal portfolio bond gains nothing from the allowance. If the policy lets you select assets outside the permitted categories, a deemed gain each year of 15% of premiums plus earlier deemed gains is charged whatever you withdraw. See the personal portfolio bond rules.

A calculator comparing the bond with direct ownership of the same investments sits on tax efficiency for UK residents.

Questions about the 5% allowance

Sources and authorities

Read as at 23 September 2026 for the tax year 2026/27. The worked examples are hypothetical and show every step; the table from IPTM7620 reproduces HMRC's own figures.

• ITTOIA 2005 s.507: the allowance on part surrenders. s.507A and s.512A: wholly disproportionate gains. s.484: chargeable events. s.491: the gain on a final event.
• HMRC Insurance Policyholder Taxation Manual: IPTM3500 (calculating gains), IPTM3505 (insurance year), IPTM3560 (periodic calculation), IPTM3596 (wholly disproportionate gains), IPTM3880 (deficiency relief), IPTM7620 (worked example).
• HS321 (2026) and HS320: the allowance and its deferral.
• gov.uk: income tax rates; savings rates from 6 April 2027.
• M&G, bond segment surrender and top-slicing relief facts (insurer technical guidance, secondary sources): segments and the allowance per segment; years for top-slicing on offshore bonds, for which the primary source is IPTM3830.

Last updated: 23 September 2026. See our editorial standards for how articles are researched and corrected.