Life insurance in IHT planning: key considerations

Where life cover is used to pay the inheritance tax (IHT) bill it’s important to know how to treat premiums and what the consequences are where the premiums are not exempt. 

There are generally two different types of life cover plans that clients will use for IHT planning; level term assurance and whole of life plans. 

• Level term cover 
  Term assurance is the most basic form of life cover, offering a lump sum payment in the event of death within the set term in exchange for a regular premium for a set number of years. If the person covered survives to the end of the term, there is nothing payable and the cover ends. Generally it is used to cover the IHT payable on large gifts where the gift uses up the nil rate band; these policies are know as 'gift inter vivos policies'.
• Whole of life plans 
  Whole of life cover is generally a unit linked type of life cover that does not have a specific term attached to it and therefore pays out a sum insured on death of the person covered. It is generally used to cover the IHT payable on death due to the estate being over the available nil rate bands and residence nil rate bands. 

Most life insurance policies used to cover an inheritance tax liability will be placed within either an absolute or discretionary trust in order to avoid the policy proceeds forming part of the estate on death and also to enable the funds to be accessed before probate is granted in order to settle the inheritance tax bill. 

Premiums 

The premiums paid to fund a life cover plan which is written into trust are transfers of value. If they are not exempt, they will either be potentially exempt transfers (PETs) or chargeable lifetime transfers (CLTs).

The annual IHT exemption of £3,000 per person can be used against premiums paid to fund a life policy. Otherwise, premiums can be paid out of income and, as long as these do not affect the normal standard of living and are regular in nature, they will generally qualify for the normal expenditure out of income exemption. 

However, don’t forget that the normal expenditure out of income exemption is only tested on death. Therefore, where a jointly owned plan is taken out, the position will need to be reassessed on first death. The premiums generally remain the same throughout the lifetime of the policy but in some circumstances the surviving individual’s income may not be large enough to cover the full premium. This means that they may now be chargeable if the exemption cannot be claimed. 

PETS 

If life cover is placed into an absolute trust, the premiums paid into the trust will be PETS if they are not covered by exemptions. 

PETs fall out of the client's estate after seven years. However, where there is a regular premium payable until death and assuming the exemptions don't apply, there will always be at least seven years’ worth of premiums in the client’s IHT calculation. PETs use up the nil rate band in chronological order. 

It’s common for people to set up a direct payment to the product provider to fund the life plan. However, where an absolute trust is used these will be classed as CLTs because a PET must increase the recipient’s estate, which does not occur if premiums are paid directly from the client to the provider. In these circumstances a trustee bank account should be set up to receive the premiums before they are used by the trustees to pay the product provider. 

CLTs

If a life cover plan is placed into a discretionary trust, the premiums paid into the trust will be CLTs if they are not covered by exemptions. 

CLTs fall out of the client's estate after seven years. However, where there is a regular premium payable until death, unless an exemption applies, there will always be at least seven years’ worth of premiums in the client’s IHT calculation. 

To avoid an IHT entry charge, assuming the exemptions are used, each individual can only pay £325,000 into discretionary trust in a seven-year rolling period. If they exceed this limit an entry charge of 20% is payable to HMRC. 

Example 

Albert wants to set up a discretionary trust for the benefit of his grandchildren to help them get on the property ladder. He wants to use £325,000 of the cash he has in the bank to invest in the trust. 

He has a large estate, partly due to the £2m value of his property, which will be subject to IHT on his death. Albert is a widower who inherited all of his wife Elsie’s estate when she died. 

He set up a whole of life policy with Elsie more than seven years ago, which is payable on second death. The premiums are £20,000 payable each year and funded from withdrawals from his investment bonds. Albert lives off his State Pension and tops this up with withdrawals from his sizeable investment bonds. He gifts £1,500 to each of his two children yearly which they use to top up their ISAs. 

His adviser has informed him that, as his whole of life premiums are funded from investment bonds, the withdrawal is treated as capital and not income. The impact of these premiums means that he can only place £325,000 less seven years’ worth of premiums into the trust without incurring a lifetime gift charge. Therefore, he can only settle £185,000 into trust as the life policy uses up £140,000 of his CLT cumulation. Otherwise, an IHT entry charge will apply. 

If life cover is used as part of IHT planning, it can be problematic if premiums are not covered by any of the IHT exemptions. It’s essential to check if there is enough income to utilise the normal expenditure out of income exemption, or factor in the premiums, when considering any additional CLTs. 

One alternative to clients paying the premiums and writing the plan into trust is to assign the plan directly to the children instead of into trust. If the children can afford to pay the premiums it means the children become the owners of the plan and can handle the payments, saving any PETS or CLTs from being created as the gifts would be made by the children rather than the parents. 

If you or a client would like to discuss IHT planning, why not get in touch and speak to one of our advisers.

Alternatively, download a copy of our inheritance tax guide, Securing your wealth for future generations.

The information in this article is correct as of 23/08/2024.

The Financial Conduct Authority does not regulate estate planning, tax advice, wills or trusts.

This article is intended for general information only, it does not constitute individual advice and should not be used to inform financial decisions.