Life assurance for inheritance tax planning

Summary

The introduction of the transferrable nil rate band in 2007 resulted in a drop in IHT (inheritence tax) receipts for HMRC in 2008/09 and 2009/10.  In 2021-22 IHT receipts were £6 billion*.

There are many IHT planning solutions that can be employed from outright gifts to family and friends, to more complex planning using trusts.  It should not be forgotten that life policies are also an important tool in IHT planning both to cover the potential tax on gifts for up to 7 years and for the remaining estate.

*Source Gov.uk, HMRC Inheritance Tax Statistics: Table 12.1 - analysis of receipts, last updated 28 July 2022. Contains public sector information licensed under the Open Government Licence v3.0

Facts and analysis

Where a gift is made to a trust or an individual, it will normally be included in the IHT calculations for the donor’s estate for 7 years.  Whether any tax is due on the gift will depend on whether it falls within the nil rate band or not.  In order to establish this, any gifts are taken into account on a strict date order, and they also form the first slice of the donor’s estate.  For example, Mary makes a gift on 1 January 2019 to Jane of £200,000, and a second gift of £200,000 a day later to John on 2 January 2019.  The residual estate, which does not include a qualifying residential interest, is valued at £400,000 on Mary’s death on 1 August 2024 and there is no transferrable nil rate band available.

The position is as follows:

The gift to Jane can use the annual exemption of £3,000 for the year the gift was made (2018/19) and the previous year (2017/18) assuming that Mary made no other gifts in these tax years.  The gift to Jane is also fully within the nil rate tax band and hence will not be subject to any IHT.  There is no annual exemption available for the gift to John since it is within the same tax year as the gift to Jane, and £131,000 falls within the nil rate tax band and the remaining £69,000 is going to be subject to IHT at 40%.  There is no nil rate band available for the residual estate, which will all be liable to IHT at 40%

The responsibility for the tax liability on the gift falls onto John.  In calculating his liability, however, he is able to use taper relief.  The gift was made 5 years and 8 months prior to Mary’s death, and this means that taper of 60% is available.  The tax due is therefore £69,000 x 40% x 60% = £16,560 on the gift and £160,000 (£400,000 x 40%) on the remaining estate.

Case Study

Let’s consider an example where a client is in the process of making gifts to illustrate where life assurance can be utilised to make sure that the funds are available to pay any IHT due.

Mr Smith is age 71 and was widowed 2 years ago.  When Mrs Smith passed away her nil rate band was fully utilised and hence there is no transferrable nil rate band available to Mr Smith.  The total value of Mr Smith’s estate before any gifts is £1,725,000, and he is looking for some advice to reduce the IHT liability on his estate or at least make the funds available to pay the tax.  Mr Smith has a grown up son and four grandchildren.  Our example assumes that the annual exemption of £3,000 has already been used, and there are no other gifts. Following advice, Mr Smith has recently gifted £325,000 into a discretionary trust for his grandchildren.  He is also going to gift £150,000 to his son to help with a house purchase. The most appropriate life assurance solutions for Mr Smith are as follows:

1.      Gift of £325,000 to the Discretionary Trust – Level term assurance policy

This is the first gift, and hence is the first asset to set against the nil rate band.  The gift is £325,000, using all of the nil rate band and means that no IHT is payable either at the time of the gift or on death.

This gift will fall outside of the estate after 7 years, but until that point it is using the nil rate band.  The ideal life assurance for this gift is therefore a 7 year level term assurance policy for £130,000 (£325,000 x 40%).  The plan should be taken out by Mr Smith, but placed into a suitable trust so that the proceeds of the policy are not paid to his estate.  The premiums should be exempt transfers under the normal expenditure exemption or annual exemption.

2.     Gift of £150,000 to his son – Gift inter vivos term assurance policy

In the event of Mr Smith’s death within 7 years of making the gift to the son this gift will become chargeable.  With all of the available nil rate band used by the previous gift to the discretionary trust it means that it will be subject to IHT at 40%. Taper relief will apply so the tax payable is as follows:

• Years 1 – 3    100% = £60,000
• Years 3 – 4    80% = £48,000
• Years 4 – 5    60% = £36,000
• Years 5 – 6    40% = £24,000
• Years 6 – 7    20% = £12,000

The ideal life assurance is therefore a gift inter vivos policy with an initial sum assured of £60,000.  The amount of cover will fall in line with taper relief until 7 years when the policy will cease.  The IHT liability for this gift would fall onto the son, and he therefore has insurable interest to effect the policy.  Alternatively Mr Smith could take out the policy under a suitable trust.  In either case Mr Smith can pay the premiums and they are likely to be exempt under the normal expenditure exemption or annual exemption.

3.     The residual estate – Guaranteed whole of life policy

The residual estate is £1,250,000. The gifts fall outside of the estate after 7 years, at which point the full nil rate band will be restored and the estimated liability will be £1,250,000 less £325,000 = £925,000 x 40% = £370,000.  Please note that if the residence nil rate band is available this could reduce the tax liability.

The most suitable type of life assurance to cover this liability is a whole of life. A unit linked whole of life could be used, but for many of these policies the sum assured is reviewed after 10 years and the premium may increase substantially at that point. A guaranteed whole of life is likely to be more expensive at outset, but is the most suitable policy for IHT planning purposes as the required sum assured will always be available for Mr Smith’s beneficiaries to pay the IHT due. The whole of life should be written under a suitable trust so that it does not form part of Mr Smith’s estate on his death, The premiums are paid by Mr Smith, and again may be exempt from IHT under the normal expenditure rules or annual exemption.

Next steps

There is little doubt that IHT planning can be complex, and as can be seen from our example it is important that any planning is executed in the most tax efficient manner.  It would be easy to take out a whole of life policy for the full amount of potential IHT due, but taking out the correct combination of policies for a client will provide tailor made cover of the correct amount at the cheapest cost to the client. 

Important information

This information has not been approved for use with customers and is based on Aviva’s interpretation of current law and legislation, and our understanding of HM Revenue & Customs (HMRC) practice as at 6 April 2021.  It is provided for general information purposes only and should not be relied upon in place of legal or other professional advice.  Both the law and HMRC practice will change from time to time and our interpretation may be subject to challenge by HMRC or other regulatory body. Aviva cannot act as legal adviser for you or your clients.  You should always seek appropriate legal or other professional advice.