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Canada Life Article - Insuring an IHT bill doesn't hit home

Insuring an IHT bill doesn’t hit home

 

So far in this series of articles we have looked at how to minimise your inheritance tax (IHT) through placing assets into trusts. But how to deal with the dilemma of a potentially large IHT bill but no liquid funds to place in a trust for example?

This may for example come about if you are financially well-off but have a large proportion of your assets wrapped up in the family home or invested in a property portfolio. Alternatively it may be that you have investments which can be readily reinvested or transferred to a trust, but the disposal would generate a large capital gains tax bill which would be unacceptable.

By failing to take action now, your family may have to make a forced sale of the family home and see a thick slice of the proceeds disappear in tax.

Taking out a life assurance policy with the sum assured matching the potential IHT bill would ensure the IHT ‘problem’ is dealt with. This option is to pay a small amount off each month now, rather than leaving your family with a large tax bill when you die. It could mean that the annual cost of insuring the taxable estate is less than 1% of the value of the taxable estate.

If you are married or in a registered civil partnership, it is almost always the case that the policy should be a joint life last survivor (second death) policy. It is vital that this is written in trust as soon as possible – preferably at the outset. Without a trust, the sum assured on death will be paid to the estate, which would increase the IHT liability.

One thing to bear in mind is that the sum assured would only equal the potential IHT bill on the commencement date of the policy.

So what if there is a need for additional cover at a later date and your health has deteriorated? Most whole life policies now offer indexation and guaranteed insurability options to cope with this situation, within certain limits.

One option is to write it under a bare trust, which makes the IHT position simpler as the premiums are exempt or potentially exempt transfers (PETs), but what if a beneficiary were to die before you or the will is changed?

I would suggest a discretionary trust may be more appropriate, although the IHT position is more complex since the rules on chargeable lifetime transfers (CLT) and relevant property trusts may come into play. But first you should bear in mind that, for either trust, the payment of the premiums is a transfer for IHT purposes. This may be offset by your annual exemption (£6,000 per year for a couple) or the normal expenditure out of income exemption – or both exemptions could be utilised together. If not, although the sum assured will be free of IHT on death, the premiums paid in the previous seven years may not be so.

For example, let us assume that a married couple, Peter and Virginia, are paying a premium of £10,000 a year for their whole life cover.

They have no surplus income, so cannot use the normal expenditure out of income exemption, but each have their annual £3,000 exemption available.

This means that they are each making a non-exempt transfer of £2,000 each year, which will be a PET or CLT.

If Peter, as the first life, dies after seven or more years, there is no death benefit (assuming it is a last survivor policy under a discretionary trust) but there is £14,000 of what are now chargeable transfers.  If the estate is left to the survivor, Virginia, there is no IHT payable at that time, but the amount available as a transferable nil rate band is reduced. (Currently, this would be £311,000 / £325,000 = 95.6923%.)

Following Peter’s death, the survivor, Virginia, has only her annual exemption meaning that the PET or CLT is now £7,000 a year, so if they die after a further seven years there is £49,000 of what are now chargeable transfers.  This is because the premium of £10,000 per year continues and only £3,000 of it is an exempt transfer. The sum assured will now be payable and if it is a bare trust no future IHT issues arise.

However, if it is a discretionary trust, the sum assured payable to the trustees is “relevant property”. If the proceeds exceed twice the nil rate band, the trustees should consider whether they should still be holding the funds in the trust when a ten-yearly anniversary occurs, as there is a risk that they may have to pay a periodic charge although, at current rates, this would be at a maximum of 6% of the excess.

This situation may also occur if the policy has a surrender value at the ten-year point, a claim is pending but not settled, or if the life assured is terminally ill. In all these cases, the trust fund could have a significant market value.

Whatever route is taken, the message is clear that if you cannot avoid an IHT bill by gifting assets and living seven years, at least you can insure it for a much smaller annual cost.

 

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