Capital gains and investors' losses: Savings linked to life insurance may have a hidden drawback, as one investor discovered. Maria Scott reports

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KENNETH Randall thought he had been the victim of daylight robbery when he discovered that Century Life, the life insurance company, had lifted more than pounds 450 from the proceeds of his Century savings scheme to pay tax.

When Mr Randall asked for an explanation, a seven-line letter arrived from Century stating that pounds 451.48 had been deducted from the total value of his policy (pounds 5,309) 'in respect of this company's liability to capital gains tax'.

So Mr Randall sought advice from the Independent on Sunday. Surely, he demanded, an individual can make gains of more than pounds 5,000 a year on investments without having to pay capital gains tax? In fact, he had unwittingly stumbled over a shortcoming of savings products linked to life insurance.

Although insurance companies make much of the 'tax-free' status of the policies, this refers only to the fact that investors do not pay income tax on the proceeds. However, the insurance companies are not entitled to the annual allowance of tax-free gains (up to pounds 5,800) that individuals are. So the companies have to pay, out of the investors' money, tax at 25 per cent on investment profit within their funds.

Mr Randall started his plan - a whole-of-life policy - in 1976. On older policies like this the gains tax is often deducted only when the policy matures.

Mike Diver, the taxation manager at Century Life, explained that although the company's tax liability was 25 per cent, Century had reduced this to 19 per cent, mainly by stripping out gains that resulted from inflation. The total value of Mr Randall's policy in February was pounds 5,309. Century then worked out the amount he paid in premiums and the amount added to his policy through reinvested dividends. That came to pounds 2,932.80, which was deducted from the pounds 5,309 to give a profit. Tax on the difference, at 19 per cent, came to pounds 451.57.

In more modern policies the tax is usually reflected in the unit price of the underlying investment. If the policy is a with-profit one it is deducted from returns added regularly to the policy in the form of bonuses.

Investors will normally be told, somewhere in their policy documents, about the tax but the effect on an investor's return may be opaque.

Unit trusts and investment trusts do not have to pay tax on their profits, so investors who make less than pounds 5,800 profits in a year will pay no CGT.

Life insurance savings schemes are also long-term contracts and the penalties for early surrender are harsh. Investors' premiums can be heavily diluted by expenses and by the cost of providing the life insurance. John Cole, managing director of the advisers Berry Birch & Noble, said investors had to decide whether their need for extra life insurance outweighed the other disadvantages. 'But people who want to create capital gains to use within their CGT allowance should look to other vehicles such as unit trusts or investment trusts,' he added. 'It is a question of looking at your objectives.'

There can be a case for investment bonds on the grounds that individuals can take up to 5 per cent of the value of the bonds a year with no tax to pay. This encashment comes from capital, but since it can be used to enhance income, it can be useful to higher-rate taxpayers.

Life insurance companies defend their products vigorously, despite the tax. According to Mr Diver, the type of policy Mr Randall took out was one of the few ways very small savers could buy into the stock market for small premiums.

Mr Randall's premiums were less than pounds 10 a month. He received tax relief on them until the policy matured, although this perk was scrapped 10 years ago. (Photograph omitted)