One key area of financial planning many of our clients are faced with is Inheritance tax (IHT) planning, and following the 2024 Autumn Budget, the planning in this area is likely to increase further. Whilst currently pension assets are exempt from IHT, their anticipated inclusion from April 2027 could see many individuals either facing increased IHT liabilities or those people who perhaps didn’t think they would have an IHT liability, now facing the prospect of having one if the planned legislation is introduced.
Whilst there is no way for pension funds to avoid having IHT payable from them from April 2027 based on proposed legislation, there are ways in which individuals could look to mitigate the impact, for instance gifting or business relief investments. However, where these have already been utilised or are not suitable, there is the potential for individuals to use a Whole of Life (WOL) insurance policy to offset part of the impact. These policies would create a separate “pot” of money to the pension funds upon death which would be available for the individuals beneficiaries.
The below takes a look at how WOL insurance works, some of the benefits and why people should consider placing the policy in to trust.
Understanding pension inheritance tax
The current position of pensions being exempt from IHT has made them an attractive estate planning tool. Many individuals with significant other assets outside of their pensions, such as cash savings, ISAs etc, have potentially been leaving their pension funds to continue to grow for as long as possible and using other investments and cash reserves to meet their living expenses. Effectively, reducing the value of assets within their estate for IHT purposes, whilst allowing the funds outside of their estate the potential to grow.
The proposed legislative changes potentially result in a rethink about these strategies. Especially where estates which were previously below the IHT threshold are now being pushed above it when pension funds are included.
This problem is exacerbated by the fact that IHT must typically be paid before probate is granted and while pension assets are often currently able to be paid out before probate, if there is no appropriate beneficiary nomination, this isn’t guaranteed.
The payment of IHT, which in the future will include IHT on the value of pension funds, compounds the issue of family members needing to settle a large IHT liability, but not having access to the funds from which to pay it. All in all, it is a headache that many people want to help their family avoid.
The recently closed consultation on the announced inclusion of pension funds for IHT purposes was based around the process and administration process of including pension funds in individuals’ estates and how this could work in practicality. Therefore, it is possible we could see some changes in how it operates.
How a Whole of Life (WOL) insurance policy can help
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 probate is granted.
Maximise inheritance – By covering the tax bill separately, assets in the estate, rather than accessing a lump sum from the pension fund which can usually be accessed before IHT is paid, the full value of other assets can pass to beneficiaries in entirety (subject to the sum assured being sufficient to meet the full IHT liability). 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.
Based on our current understanding of how IHT on pension funds will operate, the pension provider will be obliged to settle IHT due on the pension fund directly with HMRC, making a deduction from the pension fund itself. It will therefore not be possible for the full pension fund to pass to beneficiaries without any IHT deduction; however, it may be possible for the WOL sum assured to take into account the IHT payable on the pension fund and create a separate pot of money to pass to beneficiaries to compensate for the IHT deducted on the pension fund.
The financial benefits illustrated
Let’s take a look at the below scenario and the potential benefits a WOL policy could have:
Mr Bloggs is 70 years old, he has a pension worth £1m which from April 2027 could be liable for IHT. His pension is assumed to grow at 5%per annum whilst inflation is anticipated to increase at 3% each year. For the purposes of the scenario, we have also assumed Mr Bloggs would have no Nil Rate Band available upon death, and therefore the full 40% IHT would be applied to his pension funds.
He wishes to consider the benefits of taking out a WOL policy to compensate for some of the IHT liability his pension could be liable for in order to increase the overall value of funds available to his children on his death.
He wishes for the WOL policy to payout £500,000 on his death and wants the cost of the policy to be met from his pension. Additionally, he wants the WOL policy to increase with inflation.
We have assumed the growth rate on the pension fund is more than sufficient to meet the annual cost of the WOL policy throughout Mr Bloggs’ life.
The following chart highlights the impact the WOL policy could have compared to Mr Bloggs taking no action at all:
Based on the above, we can see that if Mr Bloggs dies within any of the timeframes above, by utilising a WOL policy (the blue columns), he could pass more funds on to his children by utilising a WOL policy and funding it via his pension when compared to taking no action at all (the orange columns).
It is important to add that the above strategy would not ensure Mr Bloggs mitigates all of the IHT which could be payable from April 2027. Further calculations would need to be undertaken should that be his overall objective, but the above is aimed at highlighting the impact of some level of cover being adopted compared to taking no action at all. Everyone has their own unique circumstances, and therefore the above is simply for illustrative purposes.
Additionally, any marginal income tax faced by Mr Blogg’s beneficiaries on his pension funds should he pass away after age 75 has not been taken into account.
The importance of trusts
It is important to remember that many of the benefits of a WOL policy can be undone if it’s not structured correctly, and here we are talking about writing the policy into trust.
As a standard, WOL policies are held in the name of the owner, the life assured. Where IHT is not an issue, there is often no problem with this approach.
However, in the scenario above, where Mr Bloggs was looking to insure part of the IHT liability, if the policy was held in his name, the proceeds of the WOL policy would not go directly to his beneficiaries, instead they would form part of his estate, which in turn would attract 40% on the sum assured paid out. Therefore, not providing Mr Bloggs with the solution he was looking for.
To avoid this, a WOL policy for Mr Bloggs would be taken out, with him remaining as the life assured, but the owner of the policy being listed as a trust created for this specific purpose. On Mr Bloggs’ death, the proceeds of the policy are not paid to his estate, but instead to the trust. The proceeds can then be paid to the beneficiaries of the trust without incurring any further IHT.
Summary
The calculations in relation to IHT can be complex and are potentially becoming more complex in April 2027. We are constantly monitoring and reviewing the current legislation, the proposed legislation as well as continuing to consider solutions to help ease any changes to individuals’ circumstances caused by legislative change.
Should you have any questions or concerns in this or any financial or investment matters, please feel free to reach out to use and we will always be happy to consider all available strategies and the suitability for your individual needs.
