How can life insurance help with protecting an inheritance?

Scottish Widows' Chris Dunne notes that potentially exempt transfers, which apply to those whose clients are still living after seven years after the gift is organised through the will, may leave liabilities open for clients’ relatives who die before those seven years. 

In this instance life insurance can help to protect inheritance.

“If the client passes away before the end of those seven years, there is a potential and liability for inheritance tax on this gift.

“In this scenario, a gift inter vivos life insurance policy can mitigate the IHT liability for this gift, in the absence of other exemptions. Obviously the suitability for a gift inter vivos policy depends on the liability of the rest of the estate.”

One other example of protecting against IHT payouts, according to Tony Mudd of St James's Place, is that estate creation can be taken a step further with the process of estate recreation.

The difference in a recreation approach is that rather than attempting to give their assets away, the client can enjoy them – the idea being that, before beginning this journey, they would start a whole-of-life policy that would recreate their estate upon their death.

Mudd notes that every individual has a £3,000 annual gifts exemption – the amount exempt from IHT when it is gifted.

“Using this exemption via premiums into a life policy can be an ideal way to maximise the value of this exemption via a whole-of-life policy in trust payable to their beneficiaries. Similarly, one of the most valuable, underused exemptions is the normal and reasonable expenditure exemption.”

It is important to note that sums gifted within this are also immediately exempt from IHT.

“Again, this annual gift exemption represents an ideal way of passing significant sums to beneficiaries through life assurance contributions into trust,” Mudd says.

With tax rates for IHT looming over the deceased, there are serious considerations to be made regarding protecting inheritance for many people.

Aside from the seven-year tax rule, there are other nuances at play for those placed to take gifts from relatives on death.

For example, if a person died after two years and the gift was drafted in a will and used the total nil-rate band of £325,000, with the balance of £175,000 chargeable at 40 per cent, the total liability would be £70,000.

Canada Life's Neil Jones notes this would fall on the recipient rather than the estate of the deceased.

“It is not uncommon for the recipient to have spent the money or to have used it, say to buy a property, meaning that they would not necessarily have the liquid funds available to pay the tax liability.”

In this situation, if a person was unable or unwilling to pay, HM Revenue & Customs would look for revenue from the estate, which would result in less wealth being transferred to the beneficiaries for which it was intended.

Jones explains one way to mitigate the large tax sum is to use a life assurance policy to pay a lump sum on death to make up the shortfall presented by the tax bill.

Highclere's Alan Lakey adds: “Those that are building up a potentially taxable estate should consider a life insurance policy written in trust for their intended beneficiaries, which for those who are not married or in a civil partnership, could be their partner.

“This ensures that a worthwhile sum of money reaches the right people without being taxed and without delays due to obtaining probate or letters of administration.”

Adam Higgs, head of research at ProtectionGuru, says it is important to understand that when using life insurance, a person is protecting against the IHT liability when it is inherited, not the inheritance itself.

“Life insurance will generally be used in two distinct ways. The first is to protect against an IHT liability at any time where a whole-of-life contract will be used to cover the liability on a client's (or the second of a married/civil partnered client’s) death.”

The second way is to cover the potential IHT liability if the client dies within seven years, using the previously mentioned inter vivos policy.

Jones concludes: “The total IHT payable is the same but the money is received by different people and the liability falls on different people.”

Ruth Gillbe is a freelance journalist