Pitfalls to look out for with whole-of-life assurance policies

Suitability

Some individuals with a large estate will lack the means, or desire, to gift lump sums or invest into business relief qualifying assets in order to reduce their inheritance tax exposure. 

Life cover written into trust can be an affordable and sustainable way to provide the beneficiaries with the means to pay any IHT liability.

For someone with little or no liquid assets but surplus income, whole-of-life written into trust can be an extremely tax-efficient means to provide a lump sum at the appropriate time. The policy proceeds are paid directly to the trustees so there is no need to apply for legal title before accessing the lump sum.

It is important that the timing of the payout matches the tax point so it is available when required. 

For married couples/civil partners, IHT is commonly deferred until second death, so a joint-life, second death policy would work well.

Writing whole-of-life into trust

The usual considerations over whether to use a discretionary or bare trust will apply, balancing the need for flexibility against the certainty of a beneficial entitlement and overall tax position.

The underlying trust will determine whether the premium payments are chargeable lifetime transfers or potentially exempt transfers.

For policies written into discretionary trust, trustees can direct the policy proceeds to the appropriate beneficiaries to compensate for any IHT paid. 

However, a discretionary trust does risk periodic/exit charges being payable, and potentially at a time when the trustees have no available funds to pay the charge.

If a bare trust is used, there are no periodic/exit charges, but there will be issues if the beneficiary dies before the settlor. The policy proceeds would pass via the beneficiary’s estate, but their personal representatives would not have any access until the life assured died.

Premiums

Where the premiums fall within an exemption they are immediately out of the estate, so assuming they would otherwise be falling into IHT the net ‘cost’ is 60 per cent.

The ideal scenario is for the policyholder to rearrange their assets so that they have sufficient surplus income for the premiums to qualify as normal expenditure out of income. 

Remember that withdrawals from an investment bond cannot count as income for this purpose. 

The exemption applies to the extent it is available – for example, if the premiums were £5,000 a year and the policyholder had £3,000 surplus income, then £3,000 would be immediately exempt and £2,000 would be a CLT or PET. 

Any amount not covered by the surplus income exemption may fall within the annual exempt amount. This exemption applies chronologically to the earliest non-exempt gifts in the tax year. These exemptions are only applicable to the value of the initial gift (and therefore any entry charge); periodic and exit charges still apply in the usual way.

Valuing the policy for IHT purposes

The value of a life assurance policy for IHT purposes is the higher of:

1. Premiums paid to date; or
2. Market value, which is related to the health of the life assured. This has implications for the calculation of periodic and exit charges.

Beware the 10-year anniversary

Two scenarios may significantly increase the charge due on the 10-year anniversary of putting life assurance into a discretionary trust.

First, if the settlor is in ill health at a 10-year anniversary, the value for IHT purposes is likely to be the market value, which will be close to the amount of cover. Where that value would mean there is a periodic charge, the trustees will have an IHT liability but no means to pay it – see Box 1.

The second scenario is if the life assured dies shortly before the 10-year anniversary but the trustees can’t pay out before the anniversary date – see Box 2. 

Planning considerations

When setting up a new whole-of-life policy where the required level of cover is close to the available nil-rate band, several smaller policies could be set up on different days in line with the Rysaffe principle. This will reduce the risk of a periodic charge.

When reviewing the suitability of a whole-of-life policy written into trust, there are three key areas to consider:

1. Level of cover – the introduction of the residence nil-rate band may mean the liability is now smaller than anticipated when the policy was set up. The IHT liability is a moving target, but the aim is to ensure sufficient funds at the right time to ensure a smoother estate administration period.
2. Level of premiums – are they falling under exemptions? If not, there will be implications for any other gifting plans. Is it possible to restructure the client’s investments so that they generate more income that means the premiums fall under the normal expenditure exemption?
3. Trustees – ensure there is an appropriate range so that there are sufficient people to administer the trust on the settlor’s death. Make sure that trustees of a discretionary trust are aware of the periodic charge and that they might need to act promptly on the settlor’s death if this occurs near an anniversary date to minimise the impact of periodic and/or exit charges. 

Trustees should not be referred to as “the personal representatives of my estate” because that would pull the value of the policy into the estate and hence expose it to IHT.

Victoria Harman is senior technical expert at Hargreaves Lansdown