Could life insurance solve your inheritance tax problem?

Worried about the inheritance tax bill that might be due on your estate? One increasingly popular way to address IHT is a life insurance policy specifically to cover the bill.

That way, your family will get a payout, just when they need it. But while it can provide a quick solution, it’s a costly option with several potential pitfalls to navigate first. Here’s what you need to consider before you sign on the dotted line.

What’s on this page?

• Why are more people considering life insurance for IHT?
• Using life insurance in your IHT planning
• Life insurance options
• How much does IHT insurance cost?
• The drawbacks of life insurance for IHT
• The importance of advice

Why are more people considering life insurance for IHT?

With new rules announced in the autumn 2024 Budget set to drag more people into the IHT net, advisers say enquiries about using life insurance to cover a future liability have rocketed.

Fewer than one in 20 estates currently pay inheritance tax (IHT) according to government statistics. But the numbers are growing.

The key rule change is the removal of the IHT exemption on pensions. From April 2027, anything left in your pension when you die will become part of your estate for IHT purposes and potentially hit with a tax charge of 40%. 

The government estimates that this will mean an additional 10,500 estates will pay IHT in the 2027/28 tax year, with a further 38,500 facing a bigger bill. Overall the average IHT bill is expected to increase by £34,000. 

Rising property prices and frozen IHT nil rate bands will only add to these numbers. The nil rate band was set at £325,000 in 2009, and the residence nil rate band at £175,000 in 2020 – and both are frozen until at least 2030. 

Using life insurance in your IHT planning

Life insurance provides a lump sump payout that can cover an IHT bill. That means your beneficiaries won't need to sell assets or use savings to pay the tax.

This can be particularly helpful if you have concerns that your executors might have problems paying the IHT bill within the fairly short timeframe. It must be paid within six months, which is often before money can be released from the estate.

Alan Richardson, head of product at LifeSearch, says: “The life insurance company can release the money within days, if not weeks. You can’t access money in the deceased’s estate until probate is granted so, without a life insurance payout, you might have to consider remortgaging your home or taking out a bridging loan to pay the IHT bill.”

Life insurance options

When it comes to using life insurance in IHT planning, the most common arrangement is a whole of life policy. As the name suggests, this means it is in force until the policyholder dies, as long as all the premiums are paid.

Whole of life policies can be taken out as an individual or a couple. Robin Melley, managing director of Matrix Capital and a spokesperson for the Society of Trust and Estate Practitioners (STEP) explains: “Married couples, or those in a civil partnership, can leave their estate to each other IHT-free.

As the IHT liability falls due on the second death, a whole of life, joint-life, second-death policy is suitable for these circumstances.”

Seven-year life insurance policies are another IHT planning option if you want to ensure any IHT liability is covered on a gift. Gifts that aren’t covered by your allowances are known as potentially exempt transfers and take seven years to leave your estate. 

Sarah Coles, head of personal finance at Hargreaves Lansdown explains: “If you die before the seven years is up and the gift is below your nil rate band, it’s brought back into your estate. A seven-year level term assurance policy would cover the extra tax.”

If your generosity sees you giving away gifts worth more than your nil rate band (£325,000), another type of life insurance, a ‘gift inter vivos policy’, may be more appropriate.

Gifts made in your lifetime that are above your nil rate band are subject to taper relief, which means the IHT on them reduces on a sliding scale from three to seven years after the gift is made. So cover reduces on these policies in line with the shrinking size of your bill.

Why is this only useful where you have made very large gifts (more than £325,00)? The reason is that gifts within seven years of your death will use up some of your available nil rate band.

This means there won’t be any IHT payable on lifetime gifts below £325,000 in total and therefore taper relief won’t apply (instead, when you die your estate will have a reduced nil rate band as you’ve already used some of it.) Even if gift inter vivos provides as much cover as you need, Coles recommends shopping around.

“Although a level policy gives you more cover than you need, it’s a bigger market so you might get a more competitive deal,” she explains.

How much does IHT insurance cost?

While life insurance might seem like a simple way of tackling your IHT woes, it’s not a cheap solution. This is particularly the case with whole of life cover – unlike term assurance, it’s not a case of if the policy will pay out but when.

For example, figures from LifeSearch show that a 65-year-old couple would need to pay £676.48 a month to cover £500,000 on a whole of life basis. For a 75-year-old couple that rises to £1,146.77 a month.

One big factor in the cost is the amount that you want the policy to cover – usually this is how much you expect your estate’s future inheritance tax bill to be.

To calculate this your adviser would consider the value of your home, savings and investments, any art, jewellery or other possessions and deduct the nil rate band (and residence nil rate band, if you’re leaving your main home to a child or grandchild). IHT would be charged at a rate of 40% on the taxable portion of the estate.

You should also consider if you want this amount to change in future. Cover can be indexed so it increases over time. Or, depending on the policy you take out, you may be able to use a ‘guaranteed insurability option’ to increase cover without needing a new medical examination.

These options are designed to cover life events such as marriage and divorce that might increase the level of cover you need, as well as scenarios like receiving an inheritance or new tax rules that increase your IHT liability.

Although we are talking about life insurance for IHT, essentially it’s a policy that will pay out a defined amount – it doesn’t have to be used to cover the tax bill.

So if for any reason your estate’s IHT liability reduces (for example if IHT allowances increase in future or you’ve had to spend a lot on care costs), your beneficiaries would still get the cash.

The type of premium you select will also affect the affordability of your cover. Fixed premiums are more typical, but not the only option.

Jonathon Jay, UK managing director at Hoxton Wealth, explains: “Guaranteed premiums give certainty but start higher, while reviewable premium rates are cheaper initially but can rise significantly in later years.”

The drawbacks of life insurance for IHT

Because of the relatively high cost, some people consider life insurance for IHT to be a last resort. Richardson suggests exhausting all the other IHT planning strategies, including gifts, trusts and annual exemptions, before considering insuring a liability.

“Once you’ve removed as much as you can from estate, then look at insurance,” he suggests. That said, it’s hard to predict, since the cost of your life insurance will depend on how long you end up living for.

A life insurance policy is easier to put into trust, and therefore outside of your estate for IHT purposes, compared to cash savings or investments. An insurance policy might end up giving a better return than if you saved or invested the cost of the premiums instead (assuming that IHT would then be due on those savings or investments).

But it will largely depend on how long you live (or how long you both live, in the case of an insurance policy). As well as the overall cost, it’s essential to consider the long-term affordability of any cover you take out, especially if you’re using whole of life cover.

For example, if you take out a joint life policy, your joint income might go down after the first one of you dies. Melley says: “When the first person dies, their pensions may stop, leaving their spouse with insufficient income to pay the ongoing premiums.

“This can result in the policy being cancelled, collapsing the planning and effectively wasting the premiums that were paid up to that point.” It’s also essential that any life insurance is written in trust, especially as this ensures you don’t pay IHT on the payout.

Jay adds: “By writing the policy into trust, the proceeds fall outside of the estate and are paid directly to beneficiaries. This is invaluable during what is usually a stressful time.”

It’s important that this process is done correctly. Your adviser, or the life insurance company, will be able to provide you with the right trust forms to protect a future payout.

The importance of advice

Life insurance may be a straightforward solution to an IHT problem that simply won’t go away but, given the amounts at stake, it’s an area where specialist advice is essential. Jay says: “Without advice, there’s a real risk of paying too much for unsuitable cover, or worse, leaving your heirs with a policy that fails to achieve its purpose.”

As well as recommending the most appropriate cover for your liability, they can structure any IHT planning tax-efficiently. This might include taking advantage of the regular gifts from income exemption to ensure life insurance premiums are immediately outside your estate.  

And, as Melley explains, a specialist might be able to recommend a completely different approach to your IHT planning. “A properly qualified professional adviser will first investigate ways in which your estate can be better organised to minimise the level of IHT,” he says. “Sometimes, that might mean a life insurance policy isn’t required at all.”