Insurance Policies and IHT Bills

Planning to mitigate your Inheritance Tax liabilities can be one of the most difficult pieces of financial and legal manoeuvring that you will have to go through during the course of your life. Inheritance Tax or IHT, is one of the most loathed duties levied in the UK, and many people go to extreme lengths to try to avoid it. It should come as no surprise, then, to hear that the government has recently put in place new measures to make IHT avoidance more difficult.

These measures have targeted those who use trusts to attempt to mitigate their IHT bills. This had a serious effect on the insurance industry, who offer policies that will cover IHT on the policy holder’s death. After considerable pressure from the insurance industry the rules were relaxed, but they have still made the use of insurance policies to pay IHT more complex.

Whole of Life Policies

Under the new rules, using an insurance policy to pay your Inheritance Tax bill is still possible. This is generally achieved through what is known as a ’whole of life’ policy. This means that, in exchange for the payment of periodic premiums from the policy holder, the insurance company promises to pay out a sum that is guaranteed to cover the Inheritance Tax bill that is accrued on death. However, this type of policy relies on one important principle: they must be written in trust.

If the insurance policy in question was simply to make the payment into the policy holder’s estate, it would in itself raise the IHT liabilities of the deceased and therefore increase, rather than lower, both the bill and the beneficiaries’ ability to pay. In order to avoid this, insurance policies of this type are therefore written in trust. This means that the payment is not considered part of the deceased policy holder’s estate, and is therefore not subject to Inheritance Tax.

Trust Types

The type of trust that you use, however, is another important consideration. There are two main types of trust that are used in this situation – the ‘bare’ trust and the ‘interest-in-possession’ trust. The bare trust is the simplest to understand and implement. Essentially, under this agreement the insurance company will make a payment equal to the Inheritance Tax bill, and this payment will be made directly to the policy holder’s children. It is then their responsibility to settle the bill either with HM Revenue and Customs, or with any other beneficiaries who have already paid duties.

The interest-in-possession trust is more complex, but can be more efficient in some circumstances. Again, the insurance company guarantees to match the IHT bill, but in this case control over the money is conferred on a trustee (or several trustees). It is their responsibility to divide the money between all those who have had to make payments, as they see fit.

The major drawback associated with this agreement, however, is that the new government rules have placed a 6% flat tax on any such insurance pay-outs. While this is certainly less cumbersome than the 40% IHT that would otherwise be levied, if you want to avoid this duty you will need to use a bare trust.

The Downsides

Using an insurance policy to pay off an IHT bill is not for everyone. In the first instance, it should be noted that these policies tend to be expensive, and many people find that their premiums become unaffordable, particularly if their estate grows. On the other hand, if the value of your estate falls to below the IHT threshold (for example, if you downsized your house), then the insurance company will make no payment and you will essentially have lost your premiums. For all these reasons, it is absolutely vital to talk to an IHT specialist before making any decisions on this or related matters.