How Whole of Life insurance could help fix your new pension inheritance tax problem

Inheritance tax (IHT) planning is a critical part of your wealth management strategy, and it’s become ever more so with the announcement of changes to IHT rules in the 2024 Autumn Budget. While pension assets have previously been exempt from IHT, their expected inclusion from April 2027 could see many estates increase their IHT liability overnight if the legislation is enacted as planned.

A Whole of Life (WOL) insurance policy can be an effective way to cover an IHT bill, particularly where other strategies such as gifting or business property relief have already been utilised.

Here, we look at how WOL insurance works when it comes to IHT, the benefits of using a policy to settle an IHT liability, and why people should consider placing the policy in trust.

The previous position of pensions being exempt from IHT has made them an attractive estate planning tool. The typical advice for many people with other assets outside of pensions (such as cash savings, ISAs and general investment accounts) has been to leave the pension assets untouched for as long as possible, using those other accounts to meet living expenses.

This is all set to change if the legislation proceeds as announced, resulting in many estates which were previously below the IHT threshold to be pushed above it, and those who were already liable for IHT looking at a potential major increase to their liability.

The full 40% IHT rate is set to apply to pensions that are passed on with no reliefs or exemptions. For example, this could see a pension pot worth £1 million attract an IHT bill of £400,000.

This problem is exacerbated by the fact that IHT must typically be paid before probate is granted. While pension assets may sometimes be able to be paid out before probate, if there is an appropriate beneficiary nomination, this isn’t guaranteed.

It could create a situation where family members have a large liability they need to pay, but don’t have access to the funds from which to pay it. All in all, it could prove to be a headache that many people want to help their family avoid.

A WOL policy is a life insurance plan that pays out a guaranteed lump sum on death. This lump sum can be used for many purposes, such as paying off debts, providing funds to surviving family, or in this case, paying an IHT liability.

There are some key benefits to using a WOL policy to manage an IHT liability.

Maintain liquidity

Beneficiaries of the WOL policy can receive a lump sum to pay the IHT liability, preventing the need to fund the liability themselves, sell assets to fund it or withdraw pension assets in a way that may not be tax efficient.

Avoid probate delays

Having access to funds can avoid delays in getting probate finalised, as IHT must be paid before this can happen.

Maximise inheritance

By covering the tax bill separately, pension assets can remain invested. This provides an immediate benefit to the size of the estate in that the 40% tax isn’t deducted, but the overall benefits are far greater than that.

Maintaining the full value of the pension provides the ability for the full amount to continue to compound for as long as it remains invested. This can maximise the potential long-term value of the inheritance, but of course investing comes with risk and values can go down as well as up.

Below we’ve created an illustrated example of the power of a WOL policy for estate planning purposes. The dark purple section represents the pension value that would be passed on based on a £1 million pension pot and 40% IHT rate. As you can see, in year one, this equates to £600,000 net.

For the purposes of this example, we’ve calculated that a WOL policy of £800,000 could be paid for through pension withdrawals, without dramatically changing the capital value of the pension over time. This is illustrated by the dark purple net pension value, which stays relatively static over time.

The light purple represents the WOL policy payout, which would be indexed-linked to increase over time.

The red line is the projected net inherited amount if the pension was not withdrawn at all. The result in this example shows that implementing a WOL policy and funding the premiums via pension withdrawals improves the estate’s net position even if the life assured lives until they are 100.

Indeed, if the life assured were to die at 90, the estate would be better off by over £600,000. This is, of course, just an example for illustrative purposes, and your own situation could be different. However, it shows just how much of an impact WOL cover can have, even if the life assured lives (and pays premiums) for a very long time.

The natural next question, and one of the most common from our clients, is what’s in it for the insurance company? By definition, a WOL policy can be in place for your whole life, and death is a certain event.

When offering WOL insurance policies, insurers might risk financial loss on some policies. However, they manage this through cross-subsidisation. This means they spread the costs and risks across many policyholders and products, balancing out financial outcomes.

WOL insurance premiums can be substantial, especially in later years. There are many people who take out policies and fund them through cashflow. These policies inevitably become too expensive and are cancelled before they pay out.

Much like any other forms of insurance, such as car or home, the insurer calculates their premiums based on a certain percentage of policies never paying out, to balance the large payouts of a smaller number.

This is why it is key that a WOL policy takes into account your overall financial plan, to ensure that funding the premiums until death are affordable. Otherwise, the policy could end up being a waste of money.

Many of the benefits of a WOL policy can be undone if it’s not structured correctly. Specifically, through the use of a trust to hold the policy in question. The typical way to take out a life insurance policy is to hold the policy in your personal name (i.e. as the ‘owner’ and the ‘life assured’). While this may be fine for families who don’t have any major IHT concerns, it does not work for those that do.

The reason for this is that in the above scenario, the benefits of the insurance policy would not go directly to the beneficiaries and would instead form part of the estate. For example, a life insurance policy worth £1 million could attract further IHT of £400,000. This is hardly an efficient solution.

To avoid this, a WOL policy can be taken out with you remaining as the life assured, but the owner of the policy being listed as a trust created for this specific purpose. On death, the proceeds of the policy are not paid to the estate, but instead to the trust. The proceeds can then be paid to the beneficiaries of the trust without incurring any further IHT.

The first step in taking out an appropriate policy is to calculate your potential IHT liability. Determining your current expected IHT liability can be complex, but this is where you can benefit from expert advice. This is especially true when planning to cover this liability with a WOL policy, as consideration needs to be taken on the growth of your estate over time and the subsequent indexing of the policy to broadly match the liability.

There are a number of steps a financial planner will go through to calculate your potential IHT bill.

1.     Collate asset and liability details

This step can range from simple to complex. Some estates may be made up of relatively straightforward assets such as cash and equities, while others could involve business assets, minority stakes in investments, alternative assets such as art or wine, trust benefits and more.

It’s also important to consider any gifts that have been made in the previous seven years, as they may need to be included in the IHT calculation if they are classed as potentially exempt transfers (PETs). For gifts that do classify as PETs, consideration needs to be taken on any taper relief that will be applied, as the value of the gift which falls inside the estate reduces proportionally over the seven-year period.

The first part of the process is to understand the full picture of your assets, and a financial planner can help work through the details to provide an accurate current position.

2.     Calculate net estate

The total current estate value (the gross estate) is only the starting point. From there, various allowances and reliefs can be applied. We’ve already mentioned taper relief on gifts above, but there may also be business property relief or agricultural property relief.

These reliefs are in addition to the standard nil rate bands and residence nil rate bands which will apply and could include additional inherited nil rate bands if a previous husband, wife or civil partner has died.

3.     Estimate current IHT liability

Once these calculations are done, a financial planner will be able to provide an estimate of the IHT liability of your estate. This can only ever be done based on the rules as they stand now (or expected changes which have been announced, such as the pension inclusion from April 2027), so it will always need to be under review.

From this point, a financial planner can also provide advice on how best to manage the IHT liability both now and into the future. This advice could include strategies like gifting, IHT-friendly investments or a WOL policy.

WOL insurance can be a valuable tool for estate planning, particularly for covering IHT liabilities on pension assets. By securing a policy that provides liquidity at the right time, you can protect your beneficiaries from financial strain and ensure your wealth is passed on efficiently.

To understand how we can help you with IHT planning and using WOL policies effectively, book a free initial consultation with a financial planner at Evelyn Partners.