Protection for your inheritance

A life insurance policy can be used to provide funds to meet a potential inheritance tax liability. This arrangement thereby allows more family assets to be passed on to your heirs rather than the Inland Revenue.

When does the tax arise?

Inheritance tax is potentially payable if the value of your estate at death goes over a certain amount. This is subject to change normally in the budget each year and is currently (2004/5) £263,000.

For a married couple the potential liability arises only on the death of the survivor, not the first to die. For a single person it arises on their death. The tax bill normally has to be paid before probate can be granted. This could mean that a loan has to be taken out before family assets can be sold to pay the bill.

How does life insurance help?

One solution to meeting the liability is to use a life insurance policy to provide the capital at death to pay the tax bill. The proceeds from the policy are paid free of tax. The plan is set up under a Trust so does not form part of the deceased’s estate for inheritance tax purposes.

The funds are paid to the Trustees of the Trust who then pass them on to the beneficiary(s) to meet the tax bill. As the policy is in Trust, probate does not have to be proven, so the funds can normally be paid by the insurance company within a few days of a claim.

What type of policy is used?

In the case of a married couple a whole life insurance policy is used which is set up in joint names and payable only on the last to die. For a single person a whole life insurance policy would also be used and set up in his/her sole name.

In both cases the plan is set up in Trust and the beneficiaries are normally the heirs to the estate. In most cases this would be the children of the deceased and or other family members.

Life-time gifts

A life insurance policy can also be used to protect life time gifts from inheritance tax.

For example, another way of reducing a potential liability to inheritance tax is for the deceased to make a gift of assets during his/her life thereby reducing the value of the estate at death.

Such gifts are termed “gifts inter vivos” and subject to certain conditions become “potentially” exempt from inheritance tax on death. To become exempt the donor has to survive 7 years from the date of making the gift.

During the 7 year period there is a risk that the donor could die and thereby render the gift liable to inheritance tax. A simple solution to this problem is for the donor to take out a life insurance policy to provide funds to meet the potential liability.

This special type of policy is called a “gifts inter vivos” policy and is set to run for 7 years. The sum insured reduces each year in line with the sliding tax scale. For example, the tax liability in the 3rd year is higher than the 6th year.

The policy is also set up in Trust to ensure that the funds are paid outside the donors’ estate. The beneficiary(s) would normally be the heirs to the estate.

Inheritance tax is a complex area and tax laws are always liable to change. You should seek professional advice from an Independent Financial Adviser.