Life insurance is often a key component of a high net worth (HNW) client’s long-term financial protection. The policy payouts provide the liquidity to cover their inheritance tax (IHT) bill after they die, allowing their estate to remain intact and preventing the need for a fire sale of any family assets.
One potential pitfall with this solution is that the payout from a life insurance policy will, if left unmanaged, be paid out directly to the life insured, and so be considered as part of their estate during the IHT calculations. This means that the payout may be charged at a 40% tax rate, creating a shortfall in the funds available to cover the overall IHT bill.
So, it is imperative that a trust arrangement be put in place to prevent insurance payouts from becoming liable for IHT. Read on to learn how this works in practice.
Life insurance payouts for high net worth clients can run into significant sums
For HNW clients, IHT is an inevitability because so much of their estate falls above the tax-free threshold of the nil-rate band. Effective tax planning utilising life insurance can help them pass more of their wealth on to the next generation while also ensuring that the probate process is dealt with efficiently.
The amount of life insurance purchased will usually match the client’s existing IHT liability. This is typically 40% of their estate above the nil-rate band and residence nil-rate band if they are leaving their home to their children or grandchildren. If the client’s total estate exceeds £2 million, the residence nil-rate band begins to taper.
It’s not unusual for clients in this position to require a sum assured of six or seven figures and so it’s important to avoid this sum falling back into the life insured’s estate on death and compounding their IHT liability.
The payout from a life insurance policy placed in trust will be ringfenced from the deceased’s estate
This is where trusts play a vital role. By utilising a trust, the payout from an insurance policy is ringfenced from the rest of a client’s estate. This ensures that, on their death, the policy proceeds are received by the beneficiaries of the trust who can then use the liquid cash to pay the deceased’s IHT bill.
A trust is a legal arrangement in which ownership of the contents is transferred to a nominated beneficiary. In the case of life insurance, the policy – and any payout arising from it – would be the property of a client’s nominated beneficiaries. As such, it would not be considered part of the client’s estate when they die, saving them from accidentally incurring any additional IHT liability.
Furthermore, by passing the policy proceeds directly to the beneficiaries, you avoid getting the payout tied up in the probate process. This leaves the liquid funds accessible to pay the outstanding IHT bill within the time frame stipulated by HMRC – typically six months from the date of death.
For HNW and ultra HNW (UHNW) clients, IHT liabilities that remain unpaid beyond HMRC’s agreed time frame can rack up significant interest charges. Holding a life insurance policy in trust can mitigate these costs.
Different trusts will suit different clients
Often HNW individuals will already be utilising trusts as part of their estate asset arrangements and it is possible to place a life policy into an existing trust. Alternatively, all life offices provide a standard trust form that can be used for their policies, although more often we find that it is best for complex HNW clients to draw up a new bespoke trust. It should be noted that trusts that hold only life insurance policies do not need to be registered on the trust register.
Both bare and discretionary trusts can be used to hold life insurance policies, with the policy proceeds passing to the nominated beneficiaries on death of the life assured in both cases. It is important to note however, that the tax treatment varies significantly between the two trust types. Care should be taken when deciding which trust to use and how the insurance premiums should be funded.
Points to consider:
- The transfer for a life policy into a bare trust is viewed as a potentially exempt transfer (PET), whereas the transfer of a life policy into a discretionary trust is deemed to be a chargeable lifetime transfer (CLT).
- The deemed value of a policy at the time of the transfer varies depending on the policy type. Term policies are not deemed to have any intrinsic value on transfer, nor at the 10-yearly charge point. However, whole-of-life policies will be valued based on the sum of the premiums paid to date, both at the time of transfer and at the 10-yearly point. So, it is crucial that whole-of-life policies are placed into trust immediately at inception to avoid the potential tax charge that will occur if they are transferred in the future when additional premiums have been paid.
- Care should also be taken when considering who will pay the policy premiums. Premiums paid by the life assured and so the settlor of the trust will also be deemed to be a PET in the case of a bare trust and a CLT in the case of a discretionary trust. It is possible to utilise assets already held within the trust to pay for the policy premiums to be paid but this should be given careful thought and each client’s situation will be entirely different.
A specialist broker can take the most suitable steps for your clients’ life insurance
Arranging life insurance for HNW and UHNW clients can be extremely complex. With a significant proportion of their estate at stake, it’s vital to take care at every step.
Working with a specialist broker can ensure that your client receives high-quality advice throughout the process and that their unique interests are best served.
A broker can help you to:
- Access the required level of cover for your clients
- Secure the best possible terms from the whole of the market
- Ensure that appropriate steps are taken at all stages of the process to prevent adverse tax implications
Get in touch
Here at John Lamb Hill Oldridge, we’re specialists in supporting our professional peers with HNW and UHNW clients. We can help you to create a bespoke protection package that provides invaluable peace of mind.
To find out more, email us at [email protected] or call us on 020 7633 2222.
The Financial Conduct Authority does not regulate estate planning, tax planning or will writing.
Note that life insurance plans typically have no cash in value at any time and cover will cease at the end of the term. If premiums stop, then cover will lapse.
This article is no substitute for financial advice and should not be treated as such. To determine the best course of action for your individual circumstances, please contact us.