Can I Cover My Inheritance Tax with an Insurance Policy?
It is commonly said that inheritance tax (IHT) is the tax that everyone loves to hate. So it is hardly surprising to see families across the country speaking to financial advisers about tactics to reduce or avoid it altogether. One of these tactics involves life insurance.
Life insurance is commonly understood to provide a lump sum (or set of regular payments) to your family if you die early. This can be particularly important to consider if you are the breadwinner and if you have young, dependent children who rely on your income.
Yet many financial advisers and planners have also used life insurance policies such as these for another purpose – namely, covering a client’s IHT bill when they pass away.
Does this really work, and is it a good idea? In this article, we’ll be discussing exactly those questions. Please note that this content is for information and inspiration purposes only. It should not be taken as financial advice.
To access professional, regulated financial advice regarding your own goals and situation, please consult an independent financial adviser.
Inheritance Tax (IHT) & Life Insurance
To quickly recap, IHT is charged on the value of your estate (e.g. possessions and property) over a certain threshold. In 2019-20, the IHT rate stands at 40% on your estate once it exceeds £325,000 in value.
There are some exceptions and caveats to this, which are important to mention. For instance, in 2019-20 you can effectively raise the previously-mentioned threshold by £150,000 if you pass on your residential property to a direct descendant (i.e. the “Additional Nil Rate Band”). This means you could, theoretically, pass on £475,000 to your children without facing IHT.
Moreover, if you are married/civil partnered then you can combine each of your allowances, meaning you could pass on even more to your children when you both die.
So, to take the previous example once more, suppose you are married and your spouse dies without using any of their allowances. Their £475,000 allowance could pass on to you (free from IHT). When you eventually die, you could pass on yours and your spouse’s estate to your children whilst combining both allowances. In effect, this theoretically means you could pass up to £950,000 to your direct descendents without worrying about IHT.
All of this is important to bear in mind when thinking about using life insurance to cover a potential IHT bill. After all, for many people, the size of their estate will not exceed these thresholds. By planning your estate property with the help of a financial adviser, therefore, you might be able to reduce the amount of IHT to the point where insurance might not be needed.
Yet clearly, these allowances are not enough on their own to reduce or eliminate an IHT bill, for many people. After all, in 2018-19 IHT receipts totalled £5.4bn and these are projected to rise to £10bn by 2030. Much of this revenue will be the result of poor estate planning, but it is also true that many people have large estates which need special attention when it comes to IHT.
Life Insurance: Pros & Cons
Using life insurance to cover an IHT bill is a relatively straightforward concept. You take out a policy which pays out a lump sum to your beneficiaries when you die. This sum should allow them to pay the IHT you anticipate will be due on your estate. To pay for the policy, you pay a monthly premium to the insurer.
In practice, however, this is not necessarily simple and it would be wise to consider your options with an experienced financial adviser prior to making any big decisions.
First of all, you will need to discern between a “term” policy or a “whole of life” policy. The former usually covers a set time period (e.g. 5-10 years), and are often cheaper but will not necessarily payout when they expire (if you survive the term). The latter typically involves higher monthly premiums, but you are usually guaranteed a payout when you die.
Secondly, you will need to consider whether you want to pay “variable” or “guaranteed” premiums. The former can be cheaper at the outset, but the premiums could be raised to unaffordable levels later by your insurer (leaving you without any cover whatsoever). The latter can be more costly, but at least the monthly costs are set for the future.
The really important thing to bear in mind is that a life insurance policy can, itself, be considered part of your estate for inheritance tax purposes. So it’s important to speak with your financial adviser about writing it into an appropriate trust, so it is not subject to IHT.
Monthly premiums can be quite high and depend on a range of factors, such as your age and health when you take out the policy. A 65-year-old (non-smoker) could be looking at £400-£500 whilst an 80-year-old (smoker) could be facing monthly premiums of over £1,000.
Whether or not life insurance is appropriate for your situation will, therefore, largely depend on the likely size of your IHT bill and whether your total premiums fall well below this figure. After all, there is little sense in taking out life insurance which ends up costing more than your IHT bill!
If at this stage life insurance still looks like a compelling option for you, then do speak to an independent financial adviser to help you make the most informed decision.
Remember, even if it looks like a good idea right now, your personal circumstances might change in the future (e.g. your estate might grow beyond what you expect). The political climate/landscape might shift as well. For instance, the government could raise the IHT threshold in ten or so years down the line.