Life assurance for inheritance tax planning
Written by Ray Coman
If life insurance were paid direct to the deceased, it would form part of the estate. Since the estate is likely to comprise of a home and other possessions, probably the proceeds would likely give rise to inheritance tax (IHT). This is because the value of the estate above the nil rate band, £325,000 at the time of writing, is taxable. The mainstream mechanism by which inheritance tax is sidestepped is via a Trust. Therefore, in most cases life insurance policies are not part of the estate in the UK and life insurance avoids inheritance tax.
However, the policyholder foregoes the right to alter life insurance written into the Trust. As alternatives, proceeds could be directed to a spouse or charitable association to benefit from IHT exemption.
The Trust, itself exempt, can be used to cover the cost of inheritance tax arising on the estate.
Technically, the creation of a Trust for the purpose of life insurance is a type of chargeable lifetime transfer. Chargeable lifetime transfers made in the seven years prior to death will reduce the nil rate band available to the estate of the deceased.
For both whole of life and term policies, open market value determines the chargeable transfer on creation of the trust. For healthy policy holders, surrender value gives an idea of market value. Policy surrender occurs when the policyholder exchanges their policy for cash prior to death. The surrender value is usually after deduction of penalties by the insurer.
In conclusion therefore, it is very unlikely that inheritance tax will be payable by the policyholder. A whole of life policy will be outside of his or her estate.
Payments into a Relevant Property Trust are usually regarded as further chargeable lifetime transfers. However, there is an annual exemption for inheritance tax, which is £325,000 at the time of writing.
Premiums tend to increase with age and there is a possibility that premiums will exceed the £3,000 a year threshold. Even if the annual allowance is exceeded, provided the gifts are made ‘normal expenditure out of income’ they will not be chargeable transfers. In the case of Bennett v IRC (1995) it was even decided that gifts do not need to be of a fixed amount to be of ‘out of income.’ It is only necessary that these gifts are affordable given the standard of living of the settlor.
Entry charges to inheritance tax should therefore be avoided when premiums are paid.
Trust have their own nil rate band, independent from that of the settlor for determining liability to inheritance tax. A potential pitfall is that a discretionary trust was created in the seven years prior to the creation of the life assurance Trust. In most cases, provided that the value of the trust does not exceed £325,000 (which is the nil rate band at the time of writing) the Trust will have no inheritance tax to pay. Given that Trusts are valued based on the total premiums paid for a healthy policyholder it is unlikely that there would be any charges.
On the death of the policyholder, the benefits are the entitlement of the Trust. They are not therefore treated as a gift of the deceased, even if proceeds exceed the premiums paid. The Trust is not liable to income tax or capital gains tax on receipt of insurance payout.
However, there are a minority of Trusts that will have a value above the nil rate band. Broadly, any nil rate band used by the estate is ignored in the calculation because the Trust is not treated as a possession of the deceased. The Trust would therefore have to have a value of over £325,000 to be taxable.
Often proceeds are paid to the beneficiaries straight after death. It is a strength of the arrangement that the lengthy process of probate can be circumvented, and beneficiaries can get funds sooner. However, in the less likely event that a Trust fund is not terminated, there could be period charges every ten years.
The scheme enables an individual to receive income during lifetime and gift capital to beneficiaries on death.
Where the settlor retains an interest in property, this causes a Gift With Reservation. If the gift is conditional such that the benefactor retains an interest, it is not treated as effective for inheritance tax purposes. For instance, if a person gifts their property but continues to live in rent free, the property will remain in their estate.
However, a discounted gift trust separately identifies what has been gifted and what remain the property of the settlor. Therefore if structured properly, there will be no Gift With Reservation and therefore no inheritance tax payable on death.