Not only can life insurance help cover a future inheritance tax liability, it can also be viewed as an investment or alternative asset.
Inheritance tax (IHT) is currently the number one concern for UK high-net-worth individuals looking to protect their wealth for future generations – a concern that is unlikely to fade in the years to come.
According to an Institute of Fiscal Studies forecast, by 2032–2033, around one-in-eight people (12 percent) in the UK will have IHT due on either their death or the death of their spouse or civil partner.
While there are ways in which IHT can be mitigated on an ongoing basis, including through spending, gifting or investing in exempt assets, one of the key approaches being used by high-net-worth individuals is taking out whole-of-life insurance designed to provide the liquidity necessary to fund the anticipated liability.
“Life insurance can be a really important tool in preserving the value of an estate,” says William Sheard, director of Relationship Management at RBC Wealth Management in the British Isles. “To all intents and purposes, it could be viewed as an investment or alternative asset. Once a policy is in place and premiums are being paid, it will be there until the insured person dies, and the proceeds can cover the IHT bill.”
Without adequate planning, up to 40 percent of an individual’s estate above the tax-free threshold of £325,000 will end up payable to HMRC . For those with significant estates, that can add up to millions of pounds lost to future generations, but worse still could require a forced sale of assets to generate funds to pay the bill. By providing a means to bear the cost, insurance can help avoid estates being broken up on death and be passed intact to those intended.
The key challenge for anyone looking to use life insurance to cover IHT is working out how much cover to take out in anticipation of an unknown future liability.
“It’s not an exact science – our starting point is trying to understand which assets are likely to remain in the estate at death,” explains Nick Ritchie, senior director of Wealth Planning at RBC Wealth Management in the British Isles. “This typically includes the main residence, art, jewellery and other personal possessions that are illiquid and unlikely to be sold or gifted prior to death.”
A life insurance policy can be taken out to match that anticipated liability with assumptions made about future growth of these assets. It’s essential the policy is set up in trust, so that it stays outside of the estate for IHT purposes. “The beneficiaries can then use those proceeds to pay the IHT bill immediately rather than selling down other assets or taking on debt to fund it,” says Ritchie.
A key benefit of setting up life insurance in this way is that the return (upon death) is guaranteed, and the premiums are typically fixed. Cover in the multiple millions will come at a cost, with premiums likely to be tens of thousands per year. It’s natural therefore that an individual may ask if life insurance is worth it and whether they would be better off putting the equivalent into some sort of investment or holding as cash savings instead.
Actual investment returns my differ. Whole of life does not have any surrender value and in the event of cancelling the policy before there would not be any refund of premiums paid. Premiums are indicative and are subject to full medical and underwriting. Inheritance tax rates are subject to change. Premiums paid where the policy is held in a discretionary trust are chargeable lifetime transfers and may be subject to tax depending on available allowances or excess income.
Source – RBC Wealth Management.
With £10m of joint insurance cover costing £156,888 per year, the chart shows the time taken for investing premiums to beat a whole-of-life insurance policy for two 64-year-olds (net tax and charges).
This example is for a joint-life, second-death policy for two 64-year-olds. Their anticipated IHT liability has been calculated at £10 million, and the life insurance premiums required to cover that bill will be £156,888 per year.
A calculation by RBC Wealth Management shows that the insurance policy instantly provides a return of £10 million (refer to the dark blue line in the chart). This is then compared with £156,888 invested each year achieving a five percent annual return (net tax and charges).
Considering an average life expectancy of 88 years, the accumulated investment sum is £6.9 million (refer to the green line in the chart), but this would be subject to IHT; so the final return is £4.2 million after a 40 percent inheritance tax hit (refer to the orange line in the chart). This compares to £10 million payable under the life insurance policy, which is paid free from inheritance tax where appropriate trust planning has been undertaken.
An individual would have to achieve five percent every year until age 101 before the investment – net fees, tax and IHT – matched the payout on the insurance policy.
“This presents a very compelling picture for the use of life insurance when it comes to funding an IHT liability, as there is a significant return on the premiums committed to a policy” explains Ritchie. “Not only does the policy provide a means to pay the bill, but the beneficiaries of the estate are likely to receive more than they otherwise would have if the equivalent of the premiums was just left to accumulate in the estate.”
It’s worth noting that insurance doesn’t exist in a bubble. Just as the interest environment can have an impact on investments, so, too, can it affect insurance premiums. Put simply, when interest rates are higher, whole-life premiums tend to be lower.
This chart shows how, between January 2022 and January 2024, higher interest rates significantly drove down premiums. For £1 million of whole-of-life cover on a joint-life, second-death policy, an average premium for a 50-year-old fell by 36 percent.
* All premiums are indicative only and assume standard rates for a client that is a non-smoker. Quotes are subject to full medical and financial underwriting.
Source – RBC Wealth Management
“The improvement in premium pricing following interest rate rises makes it an attractive time to consider the role of insurance as once the premiums are set, they are fixed for the life of the policy and are unlikely to remain as competitive if interest rates decline” says Ritchie.
“While the benefits of life insurance in an IHT context are clear, it’s important to view this as part of the bigger estate- and wealth-planning picture,” says Sheard. “For example, premiums will likely be taken from earnings to begin with, but they may subsequently need to be drawn from pension income, interest and dividends from savings and investments, or potentially from cash.”
The key is to build the ongoing premium into a cashflow model and ensure it can be funded sustainably from whichever sources a person has at their disposal.
It’s also possible that a person plans to use IHT exemptions – such as gifting – during their lifetime. Potentially exempt transfers (PETs), for instance, enables someone to make gifts of unlimited value, which will become exempt if they survive for a period of up to seven years after they make the gift.
These need to be given advance thought, however. A Freedom of Information (FOI) request from RBC Brewin Dolphin to HMRC has revealed that in the 2020-21 tax year, 13,380 of these lifetime gifts became subject to IHT when the donor died within the seven-year period. According to the FOI data, the top 50 failed gifts averaged £3.6 million after allowances and exemptions, which would trigger a bill of up to £1.45 million if the PET failed within the first three years. Short-term insurance can be used to cover any IHT arising during the seven years after making the gift protecting against this worst case scenario.
Other estate-planning considerations include having a will in place, putting money into trust for grandchildren and having discussions about family business succession. A combination of strategies may be required and should be regularly reviewed to adapt to changing family circumstances and legislative environment.
If an individual is thinking about taking out an insurance policy to cover an IHT liability, there are additional matters to consider.
To ensure a person’s assets pass to future generations in the way they want them to, it helps to get advice regarding all the implications, including navigating the inheritance tax situation.
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