This blog explains how life insurance works, how it can protect your estate from IHT, and where it falls short.
For many families, Inheritance Tax (IHT) feels like a problem that only the very wealthy or those with complicated financial affairs need to worry about.
It isn't. But for a growing number of people, the realisation arrives too late to do much about it.
The threshold below which no IHT is due has been frozen at £325,000 since 2009. It's set to stay there until at least April 2031. Property values, meanwhile, have continued to rise in that time.
It means the gap between what many estates are now worth and what the rules were designed to tax has narrowed sharply for thousands of households who never considered themselves wealthy enough to have an IHT problem.
Life insurance can play a useful role in managing that liability, but only under specific conditions, and only if you understand what it does. This blog explains how life insurance works, how it can protect your estate from IHT, and where it falls short.
How IHT works
Inheritance Tax is charged at 40% on the portion of your estate that exceeds your available threshold. The standard nil-rate band is £325,000 per person. On top of that, the residence nil-rate band adds up to £175,000 where a qualifying property passes to direct descendants, giving a potential combined threshold of £500,000 per person.
Married couples and civil partners can pass unused allowances to each other, which can take that combined figure up to £1m. But the residence nil-rate band begins to taper away once an estate exceeds £2m, reducing by £1 for every £2 above that threshold.
A growing number of households get caught in the IHT in net each year, because while the thresholds have stayed static, asset values, particularly property, have risen steadily over the past ten years.
How can life insurance help?
Life insurance doesn't reduce the size of your estate or lower the amount of tax owed.
However, it can provide a cash sum that your beneficiaries can use to pay an IHT bill, meaning they may not have to sell property, investments or other assets to meet it.
For estates with wealth tied up in illiquid assets like property, it can make a meaningful difference at a time of great emotional distress.
But there's an important caveat. Your life insurance policy must be written in trust. If it isn't, the payout will form part of your estate when you die. That means it gets added to your estate's value, potentially increasing the very liability it was supposed to address.
What 'written in trust' means
When a life insurance policy is written in trust, the payout sits outside your estate. The policy is legally owned by the trustees rather than by you, so it doesn't form part of the estate on death. Instead, it passes directly to your named beneficiaries and isn't subject to IHT. Without that structure, the money would land within your estate, go through probate, and may be taxed before reaching the people you intended it to help.
IHT is due within six months of death. Probate, the legal process through which estates are administered, often takes longer. A life insurance policy written in trust bypasses probate altogether, which means the funds are available quickly, at the point they're needed.
There are three main types of trust to choose from. Bare trusts (also known as absolute trusts) name fixed beneficiaries whose interests can't be changed once the trust is set up. Discretionary trusts give trustees more flexibility to distribute funds among your potential beneficiaries, which can be useful if your family circumstances might change over time. Flexible trusts sit between the two.
The right structure for your trust will depend on your aims and circumstances. It's not a decision to make without professional input, so speaking to an experienced mortgage and protection broker is essential.
Which type of policy do you need?
Not all life insurance policies are suitable for IHT planning, and understanding the distinction between them is important.
A whole-of-life policy, as its name suggests, runs for the rest of your life rather than a fixed term. Because your IHT liability doesn't expire, you'll need cover that doesn't either. Whole-of-life cover, written in trust, pays out whenever death occurs.
For couples, joint-life second-death cover is common. As we mentioned above, assets can pass between spouses and civil partners free of IHT on the first death, so the liability typically crystallises on the second death. A joint policy aligns the payout with the point at which the tax falls due.
Term insurance policies have a more specific role. If you've made a large gift, known as a potentially exempt transfer (PET), you face a temporary IHT exposure during the seven-year period before the gift becomes fully exempt. A term policy running for seven years from the date of the gift can cover that window. Once the seven years are up and the exemption kicks in fully, the need for the cover disappears.
What life insurance can't do
Life insurance can cover your IHT liability, but it won't reduce it. For large estates with significant property holdings, the gap between the relevant IHT thresholds and the estate's value can be substantial, which can affect the cost of your chosen policy. The premiums on a policy written to cover a £500,000 IHT bill will be a lot more expensive than the premiums on a small term insurance policy.
Life insurance also doesn't replace the other options available to you. Gifting assets during your lifetime, structuring your pensions to keep your funds outside your estate, and using trusts for your other assets all have a role in a well-considered estate plan. Life insurance is just one piece of that puzzle, not all of it.
There's also a practical risk with joint-life policies. When the first partner dies, household income often falls. If that reduction is enough to make the surviving partner unable to maintain the premiums, the policy will lapse, removing the protection at the point when it matters most. Planning for that contingency is part of setting up the policy properly in the first place. Again, an experienced mortgage and protection broker can make sure this happens.
How can FG & Cook help?
When written in trust, life insurance is a legitimate part of IHT planning. In the right circumstances, it can give your loved ones the financial breathing space they need to meet an IHT bill without being forced to sell a family home or other assets under pressure.
However, the premiums become more expensive as you get older or your health changes, and it's more difficult to get as time passes. So, the best time to look at whether life insurance is right for you is before those variables start working against you.
At FG & Cook, protection planning is part of the conversation we have with all our clients. Alongside arranging your mortgage, we can help you understand what life insurance might look like for your circumstances and work through the policy details with you to make sure it protects what matters most. If you'd like to start that conversation, book a consultation with our team today.