Policies in Estate Planning

Life insurance policies play an important part in:

• mortgage protection / repayment;
• short term family protection against death of the bread winner;
• long term savings and protection for a surviving spouse;
• tax-efficient lifetime gifts or savings for children or grandchildren;
• tax planning to meet death duties.

Policies cannot sensibly be viewed in isolation from Wills as an integral part of estate planning. A special tax regime applies to policies with regular premiums, which coupled with special valuation rules, gives opportunities for Inheritance Tax (IHT) planning.

This Guide highlights some key points on regular premium life policies, but not death benefits under pension plans, nor lump sum investment schemes, which are subject to different tax rules.

Policies are valued for IHT at the greater of the surrender value, or the total premiums paid. The sum assured is irrelevant unless the life assured dies or is close to death. If a policy is taken out for £1 million at a monthly premium of £100, the initial policy value is only £100 and accrues at the rate of £100 per month.

The valuation rules enable policies of high maturity value to be gifted into a trust for IHT planning at negligible cost - £100 in this example. By contrast, a gift of £1 million cash in 2008 could trigger an immediate IHT liability of £137,600 (20% of the excess over the 2008/09 nil rate band (NRB) of £312,000).

Over time, some policies can acquire a “surrender value” greater than the total of premiums paid, if part of the premium is placed in a savings plan, linked to a protection policy. Few of these mixed contracts will acquire a surrender value inside 10 years but over time this will mount up. An exception is if the life assured develops a terminal illness within 2 years of an IHT valuation date. Then the value will be close to the sum assured.

If you take out a policy and do not put it in trust, when you die it will be an asset of your estate and pass under the terms of your Will. If your estate passes to a surviving spouse, it will be exempt from IHT but the opportunity will have been lost to establish a separate trust fund which would also be exempt whether applied for the benefit of the surviving spouse, children or anyone else.

Putting a new policy in trust from inception is a simple process and often free of charge if arranged by your financial adviser when setting it up. There is a further practical benefit following the life assured’s death, as the policy proceeds can be claimed by the trustees within two or three weeks. In contrast executors will be unable to claim until probate has been granted, perhaps three to six months after the death.

The size of individual policies is a factor, bearing in mind the IHT “relevant property” rules. For example, if £1 million of life cover is needed, it could be sensible to take out three separate policies so that each would be little more than the value of the NRB level. The policies need to be taken out on separate days and put in separate trusts, as they will otherwise be treated as “related property” if taken out on the same day, and have only one NRB between them.

When a policy is placed in trust, it becomes subject to the “relevant property regime” for IHT. This means that any value exceeding the NRB level will be subject to lifetime IHT at the 20% rate. Thereafter a 6% “periodic charge” applies on each 10th anniversary of the trust, with interim “exit charges” between 0.15% and 5.85% on distributions between anniversaries.

The relevant property rules are not likely to give rise to an actual IHT charge until after the death of the life assured, as the total of premiums paid or the surrender value are unlikely to exceed the NRB. If a regular premium policy is placed in trust, each premium is treated as a separate gift, likely to be covered by the exemption for gifts out of income, or the annual £3,000 gift allowance.

Once the life assured has died, the trust policy will become a trust of the cash proceeds. If the cash fund is over the NRB level at that time, some forward planning will be needed to manage the potential IHT liabilities on distributions (“exit charges”) and the 10-year anniversary “periodic charges”.

A policy taken out in trust on 1 October 2005 would not reach the first periodic charge date until 1 October 2015. Prior to that date, any distributions from the trust fund will be calculated by reference to the value of the policy on 1 October 2005 which will be no more than the first premium paid.

Any exit charges up to 30 September 2015 will therefore be nil even if by then the life assured has died, and there is a £1 million trust fund. Once the anniversary date has passed, the trust fund is re-based at its current value. Exit charges between 2015 and 2025 will be based on £1 million at the rate of 0.15% per quarter year elapsed since 1 October 2015, on the excess over the NRB at that date.

Special rules apply when a trust policy has an option to increase the sum assured. This is particularly important in the case of policies taken out prior to 22 March 2006 or earlier key IHT dates such as 18 March 1986. Policy options which include automatic cover increases without further health underwriting are covered, whereas options which do require health underwriting, may risk losing historic tax-efficient treatment.

Life policy trusts need to be considered from two points of view. One is the practical advantage of having tax free funds available following the death of the life assured without having to wait for probate. The other is the special IHT advantages which can flow from policy valuation rules, including the ability to create several trusts with their own NRB at negligible cost.