How to use life insurance to cut your IHT bill

There are many options to mitigate inheritance tax (IHT), from giving away assets during your lifetime to riskier alternatives such as investing in Aim shares. The IHT tax-free threshold has been fixed at £325,000 since 2009, although this increases to £500,000 if you give away your home to your children or grandchildren. Its real value has shrunk over the years as house prices have gone up, meaning more and more estates have been captured by it, and the government is amassing record IHT receipts. 

One less well-known strategy to reduce IHT involves taking out a life insurance policy and wrapping it into a trust. This can ensure your beneficiaries receive a lump sum at your death, which they can also use to pay the bill on the rest of your estate.

When people consider life insurance, they usually do so to provide financial protection to their dependents in the event of their premature death. While there is an element of that aspect in this method, using life insurance for IHT purposes is slightly different. 

It is typically done through a whole-of-life policy, as opposed to a term assurance policy. The former pays out at death, no matter when it happens, while the latter only pays out if the death occurs within a certain timeframe. A whole-of-life policy gives your beneficiaries the certainty of a lump sum payment when you die, meaning the premium is normally higher.

Life insurance forms part of your estate when you die and the payout is typically subject to IHT at the usual 40 per cent rate if the total value of the estate is above the tax-free threshold. But writing your life insurance policy into a trust means that the sum assured is paid into the trust itself when you pass away, which normally means it is free of IHT. 

Trusts are in general an effective way of mitigating IHT, although there are some complications and costs to keep in mind (see ‘How to use trusts to mitigate inheritance tax’, IC 16 August 2023). If you only need a trust for the purposes of a life insurance policy, insurance companies typically provide a sample trust deed at no additional cost that you can then adapt. But depending on the complexity of your circumstances, it may still make sense to take legal advice.

Discretionary trusts offer more control and flexibility and can include a range of potential beneficiaries. The trustees manage the assets, decide who receives a benefit from the policy and how much is paid. By contrast, an absolute trust means the named beneficiary is absolutely entitled to the money.

Using a trust can also help in cases where the family situation is complicated, says Shaun Moore, tax and financial planning expert at Quilter. “If there are specific wishes regarding the distribution of the insurance proceeds among beneficiaries, a trust provides the necessary flexibility and control. This becomes even more crucial in complex family situations, such as blended families or where there are multiple beneficiaries,” he explains.

Petronella West, chief executive officer of Investment Quorum, says that using life insurance to cover IHT can be “very powerful”. But you must make sure you can afford the premium, not just now but in the future – for example once you retire. “The worst scenario is if you get to, say, 90, run out of money after paying £300,000 in premiums over the years, stop paying and then die the next day,” she explains. For this reason, ideally the premium for a whole-of-life policy shouldn’t come from your income, but from capital you do not need and intend to pass on to your beneficiaries.

You should also consider your risk appetite and the cost of the policy. Life insurance can be good value for money, and West says that if you take out a £1mn policy when you are around 50 and in reasonable health, and live until about 80, the total premium could work out in the region of £300,000, a third of the final payout. But the final total cost depends on a number of factors, including your health and habits, so it will vary significantly from person to person.

It is entirely possible that you could generate higher returns by investing the money instead. For example, you could give the money to your beneficiaries during your lifetime. As long as you survive seven years after the gift, the cash will not form part of your estate, and your beneficiaries can invest it for growth. By contrast, life insurance offers more control on the assets and certainty over the final payout.

Liquidity

For estates that are comparatively illiquid, usually because they comprise a high proportion of property assets, life insurance can be a way to help your beneficiaries pay the bill. Niki Patel, tax and trust specialist at St James’s Place, notes that if there are no liquid assets in the estate to pay IHT, the executors may need to take out a loan, with the interest costs that come with it. Setting up a life insurance policy in a trust is a way to prevent this.

In some cases, IHT can also be paid in instalments to HMRC, over 10 years or until the property is sold, but this also accrues interest. On the other hand, if you don’t have a lot of cash at your disposal, you should consider even more carefully whether you can afford the premium in the long term.

Another advantage of setting up a policy into a trust is that beneficiaries don’t need to wait for probate to be granted to the rest of the estate to access the money. Probate can be a slow process, and average wait times have increased significantly in the past year as the service struggles to clear its current backlog. The executors can’t sell a property that formed part of an estate before probate is granted, so if the estate does not have enough liquid assets to settle IHT and the wait is prolonged, the IHT bill starts accruing interest. The final reason to think carefully before wrapping a life insurance policy into a trust is that you can’t remove it afterwards – the decision is irreversible.