Do I need inheritance tax insurance?

Should I consider taking out inheritance tax insurance? For FT readers with large pensions, Budget changes mean the answer is almost certainly yes.

From 2027, defined contribution pensions will be included within a person’s estate when calculating IHT bills. For many, this will push the value of their estate over £2mn where the additional residence nil rate band for passing down the family home starts to be lost.

The changes are subject to a consultation, but IHT bills are set to become more onerous for tens of thousands of families. Financial planners are already busy taking calls from worried clients asking if they should take out life assurance to cover the higher costs — and I’ve had plenty of emails from FT readers too.

How does it work?

Whole of life cover — a policy which pays out after your death — is a tax-efficient way of pre-funding your inheritance tax liability, says Ian Dyall, head of estate planning at Evelyn Partners. Let’s imagine you have estimated — perhaps with the help of an adviser — that your heirs face an IHT bill of £1mn. You take out a life assurance policy for the same value, and crucially, have it written into trust so the eventual payout does not form part of your estate for tax purposes. You pay the monthly premiums, and when you die, the trustees — your beneficiaries — can use the proceeds to settle the IHT bill promptly.

If you are married or in a civil partnership, expect to hear the phrase “joint life, second death”. This means that both of your lives are insured, but (as assets can pass free of IHT between spouses) the policy will only pay out to your beneficiaries on the second death.

What are the benefits?

It will save you tax, but also saves those you leave behind a lot of stress. Any IHT liability has to be paid before probate is granted — and while cash in your bank accounts can be accessed to pay it, most other assets cannot be touched until your executors have probate.

As well as whole of life cover, individuals who have made large lifetime gifts can take out what’s called a “gift inter vivos” policy to insure against the cost of them dying in the intervening seven years, after which gifts can pass tax-free.

Dyall gives the example of a client who gifted his son £500,000 to buy a property. This is £175,000 above the individual nil rate band of £325,000, creating a potential IHT liability for the recipient of the gift if his father dies within seven years of making it. The level of cover using a gift inter vivos policy reduces in line with the IHT taper; after three years, liability tapers down by 20 per cent; and then at 20 per cent each year thereafter until seven years are up.

However, Dyall points out that if individuals make a large gift below the £325,000 nil rate band, it would not be subject to taper relief. Say you gifted £200,000 and died six years and 364 days later. The whole sum would remain in your estate, which could increase your overall IHT liabilities, so any cover would need to be taken out to cover the full cost.

How much will it cost?

This depends on the size of the sum insured, your age and health, says Olly Cheng, financial planning director at Rathbones. The younger and fitter you are, the less expensive cover will be — insurers are betting you’ll pay a lot more of those monthly premiums before you die. Expect to fill out a health questionnaire; you may also need to attend a medical.

With a guaranteed whole of life policy, the premium is set at the outset, and does not change. Beware reviewable whole of life policies, which offer much cheaper monthly premiums initially, but as you get older (and potentially sicker) your cover is reviewed, and the premiums increase.

Evelyn recently calculated a healthy 50-year-old client would pay £1,250 per month for guaranteed cover of £1.4mn to meet his estimated IHT liability after the 2027 changes (note this is nearly triple his current IHT liability). He would have to reach his 143rd birthday before the cumulative value of his premiums exceeded the sum insured.

The cost of advice and setting up a discretionary trust would also need to be factored in, though it is possible to buy cover yourself using a broker (LifeSearch is the UK’s biggest). It’s not cheap, but some will feel there’s value in knowing you can then do whatever you want with your own money and your liabilities will be covered when you die.

How can I reduce the cost of cover?

Joint life policies tend to be cheaper (the chances of one person dying is greater than the chance of two people both dying) but any adviser worth their salt will use tax planning to limit the IHT liability you are paying to insure. You could gift more at a younger age, or simply spend more money!

“Psychologically, when you’ve saved all your life, it can be very difficult to spend more and see your net worth go down,” says Dyall. He poses the question: “What would you buy today if you could get 40 per cent off?”

It might be easier to justify splashing out on a car or a holiday if you can enjoy 100 per cent of the money before you die, when HM Revenue & Customs will take its cut.

Taking income from pensions (rather than leaving them untouched) also raises the possibility of funding regular gifts from excess income, which are not subject to IHT, though Cheng warns careful records must be kept.

You could also use the cash to fund the monthly life assurance premiums. For couples, Cheng adds that structuring gifts (and inter vivos policies) to come from the youngest and healthiest person makes cover cheaper.

Die after 75, and any pension funds you bequeath will also attract income tax at the recipient’s marginal rate. Cheng expects more people will opt to distribute pensions among their grandchildren or great-grandchildren who may benefit from a lower tax rate.

If your gifting and spending strategy reduces your IHT liability, some whole of life policies offer the flexibility to bring down the sum insured and thus reduce monthly premiums.

Finally, make sure your financial legacy does not bequeath your heirs with a nasty administrative nightmare — get your paperwork in order.

Make sure your nearest and dearest know where to find your will; records of any gifts, assurance policies and an asset register including all of your pensions (in future, your executors will not be able to calculate IHT liability without the latter). An awkward conversation perhaps, but one that should make life far more bearable for them after you’ve gone.

Claer Barrett is the FT’s consumer editor and the author of ‘What They Don’t Teach You About Money’. [email protected] Instagram @Claerb