IHT is typically charged at 40% on the value of an estate above certain available allowances and can significantly reduce the wealth passed on to loved ones.
As a result, many individuals and couples are exploring ways to protect their family’s inheritance and preserve more of their estate for future generations. One solution that is often overlooked is life insurance, which, when structured appropriately, can provide valuable protection against a future IHT liability. A life insurance policy can provide a tax-efficient lump sum on death to help offset or meet an IHT liability, ensuring beneficiaries receive more of the wealth intended for them.
Life insurance can play an important role in estate planning in several different ways. Let’s look at the three key strategies that can help reduce the impact of IHT and protect your legacy.
Term (or Gift Inter Vivos)
When a significant gift is made during your lifetime, it will typically remain within the scope of IHT for seven years. Life insurance for a fixed seven-year term can therefore be used to protect against the IHT that would become payable if death occurred and a gift became chargeable within this period.
A Gift Inter Vivos policy is specifically designed to protect against this risk by providing cover for seven years, with a reducing sum assured over that period that reduces with a profile in line with taper relief, which can sometimes reduce the tax charge on large gifts if death occurs between three and seven years.
It is only where the total value of gifts made in the seven years before death exceeds the available nil rate band, typically £325,000, that taper relief applies, and so a Gift Inter Vivos policy is typically utilised where significant gifts have been made. For other gifts, a straightforward seven-year term policy with a fixed sum assured can be utilised.
Reviewable Whole of Life
Reviewable whole-of-life policies are designed to provide a lump sum on death that can be used to meet/replace some or all of an expected IHT liability. These policies often benefit from lower initial premiums than guaranteed policies, which can appear an attractive option for some individuals.
Whilst reviewable plans can offer a lower-cost route to establishing cover initially, future premium increases can often be substantial and exponential. It is therefore important to consider not only affordability today, but whether the policy is likely to remain affordable and effective over the long term.
Guaranteed Whole of Life
Guaranteed whole-of-life policies provide cover for the entirety of your life, with both the premium and level of cover fixed from the outset. This means you know exactly what you will pay and the benefit that will be available to your beneficiaries on death.
While these policies generally have higher premiums than reviewable alternatives in the early years, the certainty they provide can be particularly valuable where there is a known or anticipated IHT liability. When written into trust, the proceeds can be paid quickly and efficiently to beneficiaries, helping them meet an IHT bill without needing to sell assets from the estate.
For business owners, there may be additional opportunities to structure life cover tax-efficiently through your company, providing other incentives such as tax-deductible premiums.
The importance of Trust Planning
Whilst a life insurance policy may seem like a straightforward answer to a complex issue, there is much more to this type of product to ensure that it can achieve what a client is setting out to do. With suitable financial advice and expertise, the real value is added by ensuring that the ownership structure and beneficiary arrangements, including trusts, are all aligned and appropriately set up. Planning with life insurance should not be considered in isolation, and ensuring that it is supported through your will, powers of attorney, gifting strategy and broader IHT and financial planning is critical.
In many IHT planning scenarios, life insurance policies are typically written into trust. Without appropriate trusts in place, the proceeds of a life insurance policy can fall into the deceased estate and therefore become subject to IHT. The absence of a trust can also mean significant delays before a policy is paid out, as the estate will need to be wound up before funds are released. However, by writing a policy into trust, the proceeds typically fall outside of the deceased’s estate and are generally paid swiftly to the trustees for distribution. For policies set up to cover a potential IHT bill, this aspect is particularly valuable in providing liquidity for paying this bill and winding up an estate.
For most IHT planning scenarios, a discretionary trust is preferred as it provides a higher degree of flexibility, enabling the trustees to have discretion over who benefits and their portion of the proceeds. This can be particularly relevant when you consider how much can change during the years a policy is in place; children marrying, divorcing, suffering ill health, or having children of their own can all influence how someone might wish for the proceeds to be distributed. Therefore, the flexibility that a discretionary trust provides can be invaluable over the term of the policy. This highlights the need for careful consideration over the appointed trustees and clear communication of the wishes of the individual(s) setting up the policy. To support this, the settlor can provide guidance through non-binding expression of wishes, to support and enable the trustees’ decision making down the line.
The importance of Trust Planning
Whilst a life insurance policy may seem like a straightforward answer to a complex issue, there is much more to this type of product to ensure that it can achieve what a client is setting out to do. With suitable financial advice and expertise, the real value is added by ensuring that the ownership structure and beneficiary arrangements, including trusts, are all aligned and appropriately set up. Planning with life insurance should not be considered in isolation, and ensuring that it is supported through your will, powers of attorney, gifting strategy and broader IHT and financial planning is critical.
In many IHT planning scenarios, life insurance policies are typically written into trust. Without appropriate trusts in place, the proceeds of a life insurance policy can fall into the deceased estate and therefore become subject to IHT. The absence of a trust can also mean significant delays before a policy is paid out, as the estate will need to be wound up before funds are released. However, by writing a policy into trust, the proceeds typically fall outside of the deceased’s estate and are generally paid swiftly to the trustees for distribution. For policies set up to cover a potential IHT bill, this aspect is particularly valuable in providing liquidity for paying this bill and winding up an estate.
For most IHT planning scenarios, a discretionary trust is preferred as it provides a higher degree of flexibility, enabling the trustees to have discretion over who benefits and their portion of the proceeds. This can be particularly relevant when you consider how much can change during the years a policy is in place; children marrying, divorcing, suffering ill health, or having children of their own can all influence how someone might wish for the proceeds to be distributed. Therefore, the flexibility that a discretionary trust provides can be invaluable over the term of the policy. This highlights the need for careful consideration over the appointed trustees and clear communication of the wishes of the individual(s) setting up the policy. To support this, the settlor can provide guidance through non-binding expression of wishes, to support and enable the trustees’ decision making down the line.
Managing periodic charges
Periodic charges are IHT levies that apply every 10 years on discretionary or relevant property trust that exceed the available nil rate band. This means that in theory a charge of up to 6% of the value above the available nil rate band could apply every ten years. Naturally, with the role of life insurance being to reduce the impact of IHT charges, this can be an area of concern. However, with careful and effective planning, these charges can be mitigated, and often, avoided entirely.
Ensuring that trusts are properly structured, considering trust creation dates, nil rate bands, and potentially the use of multiple trust arrangements can all significantly reduce exposure to these periodic charges. Where proceeds are quickly distributed following a claim, these periodic charges may never become an issue. In practice, many life policy trusts are structured so that proceeds are distributed shortly after a claim, meaning significant trust assets are not retained long enough for periodic charges to become a material concern.
Ultimately, whilst insurance and trusts on the face of things can appear to be a simple solution to an increasingly important problem, the value we add as advisers comes from far more than just the purchase of a policy. Ensuring that these products are set up effectively and in conjunction with your wider financial planning is vital to see the full benefit.
What comes next?
Life insurance can play an important role in helping to preserve family wealth and provide funds to meet a future IHT liability. However, the effectiveness of any policy depends not only on the cover selected, but also on how it is structured and integrated with wider estate planning arrangements. Trusts, gifting strategies, wills and broader IHT planning should all be considered together to ensure the intended outcome is achieved.
The potential role of life insurance in IHT planning is becoming increasingly relevant following the government's proposed changes to pension death benefits from April 2027. Whilst pensions have historically sat outside an individual's estate for IHT purposes, proposed legislation is set to bring most pension funds within the scope of IHT. As a result, individuals should review their estate planning arrangements and consider whether life insurance could help provide liquidity to meet a future IHT liability.
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If you would like to understand how inheritance tax could affect your estate and whether life insurance could form part of the solution, speak to one of our advisers today. |
