The following is an opinion piece written by Gordon Kearney (pictured), managing director and financial adviser at Fiducia Wealth. The views expressed within the article are not necessarily reflective of those of Insurance Business.
Life insurance has long been a popular choice among people looking to offset their inheritance tax liabilities. When it is expected that heirs will have to pay inheritance tax at 40% on a portion of an estate, life insurance is commonly used to create a pot of money which will cover the tax bill.
Yet this use of life insurance poses challenges. Estate planning, and especially inheritance tax planning, is a complex area, not least because the tax regulations change frequently. When a customer asks about life insurance for inheritance tax, you are not just offering advice on types of policy, you are delving into a specialist area of asset management and personal finance.
This may seem daunting. But without becoming an expert on the ins and outs of tax law and estate planning, you can still ensure you offer accurate, relevant and helpful advice by focusing on the following four key areas.
Explaining thresholds - do you need life insurance?
The first step is to ascertain whether a potential customer even needs life insurance to cover potential inheritance tax liabilities on their estate. The inheritance tax threshold - known as the Nil Rate Band - currently sits at £325,000, so 40% tax is only charged on assets over that value. If a customer is married, this is effectively doubled, as spouses can inherit entire estates tax-free when their partner dies and they can also use their threshold allowance when it comes to passing on their combined estate.
In addition, since April 2017, part of the value of a main residential property is included in the tax-free allowance. After April 2020, an individual with a home valued at £175,000 or more will be able to pass on £500,000 without their heirs having to pay inheritance tax, while for a married couple this will effectively raise to £1 million in assets.
So, inheritance tax is only a consideration for high net worth individuals and couples - an estimated one in 10 UK households break the £1 million Nil Rate Band for married couples. If your client does not believe they have assets totalling more than the threshold, they need not consider life insurance to cover inheritance tax.
Explaining costs - is it worth it?
As in all circumstances when there is a defined need for funds, whole of life insurance policies are strongly recommended for inheritance tax purposes as they guarantee a payout whenever the policyholder dies. But as whole of life assurance premiums are considerably higher than term policies, this makes covering against tax liabilities more expensive than many customers may be expecting.
For example, say you are approached by a 40-year-old customer who is married and estimates their net worth at £2 million. As things stand, they are looking at their heirs facing an inheritance tax bill of £400,000 (40% of £1 million, the amount over the married couple’s threshold). The average non-smoking 40-year-old is looking at a monthly whole of life policy premium of around £50 per £100,000 pay-out, so this customer would have to pay £200 a month.
Obviously, these costs go up with the age of the customer - you can roughly double these fees for a 50-year-old - but also with the value of their assets. A married 50-year-old with £5 million in assets could be looking at £1,600 a month. As these payments have to be kept up to keep the policy valid, it is worth having an honest conversation with your customer about whether they can sustain this level of financial commitment in the long term.
Explaining types of policy - non-profit and with-profit
Another challenge with planning life insurance to cover inheritance tax liabilities is the fact that financial circumstances and the value of assets change over time. The 40-year-old approaching you with £2 million in assets is unlikely to pass on with an estate of exactly the same size 30 or 40 years later. If the value of their estate increases, so does the tax bill.
It is important to explain to customers the difference between non-profit and with-profit whole of life policies. The option to put a portion of their monthly or annual premiums into investments creates the opportunity for the eventual payout to grow, and thus cover all or most of any inheritance tax bill as the value of an estate grows. But there are of course risks involved. A non-profit policy gives the certainty of a fixed payout, but it may fall short of what the eventual tax liability is.
Explaining trusts - keeping payouts tax free
There was a report a few years ago that revealed that half a billion pounds was being paid in inheritance tax every year straight from life insurance policy payouts. This was before the Nil Rate Band was changed to include property, but it still illustrates an important point - the value of a life insurance policy is counted as part of an estate, and is therefore liable for inheritance tax.
This somewhat defeats the point of using life insurance to offset inheritance tax. Take our example of the married 40-year-old looking for a £400,000 policy to cover her children’s tax bill. That policy alone will actually do the opposite of what she wants - it will increase the taxable value of her joint estate to £1.4million, increasing the inheritance tax bill to £560,000.
That is why it is so important to advise customers to put life insurance policies into trust. Any assets held in trust, including payouts from insurance policies, are not considered part of an estate, and are therefore exempt from inheritance tax. That means the proceeds can be used for their intended purpose.
Gordon Kearney graduated in 2000 from the University of Essex with a degree in History & Politics and began his career in financial services with the Royal London Group in Colchester working in its pensions department. In 2002 he was selected and seconded to Edinburgh to work for Royal London’s sister company Scottish Life. While in Scotland he was principally responsible for managing the company’s group personal pensions.
After 18 months of commuting and working in Edinburgh he returned to Colchester to join Fiducia in 2004 to develop its investment management service as head of investments. In 2005 he was made a director of the company and since 2010 he has had a client facing role. Not surprisingly Gordon’s specialism is investments, but he also provides broad financial planning advice. Typically, he works with young aspiring professionals, business owners and company directors.
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