How a simple IHT solution can outperform an investment
Over the last ten years, the amount Brits pay in Inheritance Tax (IHT) has more than doubled. Figures from the Office for Budget Responsibility (OBR) show that the amount of IHT paid rose from £2.4 billion in 2009/10 to £5.2 billion in 2017/18, with the OBR predicting that this figure will increase again this year.
With around one in 20 estates liable to pay IHT, it’s no surprise that we like the idea of reducing the amount of tax payable when we die. Most of us also want to maximise the amount of money our loved ones and good causes inherit.
However, many of the options currently available have their downsides. Making large gifts sometimes brings family complications whilst funding trusts are exposed to legislative changes.
However, there is one solution that’s often overlooked. Using life insurance as a pseudo-investment vehicle is often surprisingly cost-effective as well as being non-contentious as HMRC still receive their share.
A quick refresher on the current IHT rules:
The current IHT rate is 40%. You will normally pay no IHT if:
The total value of your estate is below the Nil Rate Band (NRB) of £325,000
You leave your estate to your spouse or civil partner
You leave your estate to an exempt beneficiary; for example, a charity
Your Nil Rate Band (fixed at £325,000 until 2021) may be increased if you’re widowed or you’re a surviving civil partner. Here, any unused NRB can be transferred to the surviving partner when the first person dies.
This has the effect of potentially doubling the amount of NRB available up to £650,000. This extra transferable element is known as Transferable Nil Rate Band (TNRB).
Furthermore, the Residence Nil Rate Band (RNRB) was recently introduced in addition to your NRB and TNRB. To benefit from this additional allowance, you must pass your home (or a share of it) to your children or grandchildren (this includes step-children, adopted children and foster children).
The RNRB is currently £150,000 (tax year 2019/20) and will rise to £175,000 in tax year 2020/21.
However, if your total estate is valued at more than £2 million, the Residence Nil-Rate Band (RNRB) is tapered away by £1 for every £2 above £2 million. This means that when the RNRB reaches £175,000 in 2020/21, you’ll not benefit from this additional allowance if your estate is worth more than £2.35 million.
As it stands, it means that you can potentially pass a total Nil Rate Band of £475,000 to your spouse or civil partner, meaning their threshold could be as much as £950,000 on death.
How whole of life insurance may help you maximise the amount your loved ones inherit
A simple way to ensure that your beneficiaries receive the total value of your estate is to consider guaranteed premium ‘whole-of-life’ insurance.
This type of protection ensures that the proceeds of your life insurance are available to pay any IHT liability that falls due. It means that the full value of your estate can be passed on to your beneficiaries. Furthermore, you’re often able to fix the premium you pay at the outset so this will not change throughout your life.
This is a real benefit to clients where there is a very real expectation of having surplus funds on death. Many don’t want to give away capital now for several reasons, most commonly:
The fear of needing funds for their own long-term care
They are afraid that passing on significant sums will impact upon the drive of their children
They are concerned that passing a significant sum may be lost to divorce.
The use of whole of life insurance is increasingly used as part or all of the solution. There are two main benefits to a whole of life policy:
The proceeds of the policy don’t form part of your estate when you die (assuming they are written in trust – see below)
The premiums you pay for your insurance reduce the value of your estate now, further reducing your IHT liability.
Depending on your age and health, life insurance is often very affordable. And, paying premiums while you are alive may have the benefit of reducing the value of your estate, as we saw above.
How can life assurance outperform an investment?
If you are an individual or couple that is expected to have surplus liquid funds at the end of your lives, then any investment that you make now is already being invested for the benefit of your loved ones or your estate – because you will never spend it. Investing these surplus funds is designed to achieve an investment return, though ultimately it is likely to be subject to IHT at 40%.
The idea of outperformance essentially comes down to maths. We all understand that if you took out a whole of life policy, paid just one premium and then died, then the amount you would receive on death from the insurer (the ‘sum assured’) would exceed the amount you would have received had you invested the premium instead. The invested amount would also likely be subject to IHT. The question becomes: at what point is life assurance worse than continuing to invest the premiums?
So, what does the maths tell us? For a couple, the calculations need to work on the second death of a married couple. This is because we’re able to assume that all assets will pass between spouses tax-free when the first partner dies. In the example below, for a couple aged 68 and 65, you would get a better pay-out with life insurance until one of you reached the ripe old age of 103, even if you had been investing the premiums and achieving a 5% growth rate net of income tax, CGT and all investment and advice fees. For more risk-averse investors targeting an after-tax 3% net return, one of you would need to live to the age of 111!
The sums are even more in favour of life assurance if you were able to afford an indexation option on both the playout and the premiums. This time your life insurance pay-out would typically be higher than the accumulated value of reinvested premiums if you died before the age of 111 (assuming a 5% growth rate) and 121 (for the cautious risk investor).
In both scenarios, even the higher risk investor needs to live well into their mid-90s for the investment to outperform the life assurance when considering passing surplus cash to loved ones.
The lower the assumed growth rates the greater the probability of life insurance providing a sum that’s higher than the accumulated cost of your reinvested premiums post-IHT. Indeed, assuming an RPI-indexed premium and sum assured is selected, and assuming a growth rate of 3% on investments post all fees and IHT, you’d have to become the oldest person in history to be better off reinvesting the premiums than paying for life cover.
One vital component of this type of approach is that your policy is written in trust. By doing this you can ensure that the proceeds of your life insurance policy are not included in your estate. If you don’t place the policy in trust, the proceeds are likely to be added to the value of your estate, meaning you could actually increase the amount of IHT that is paid!
Writing your life insurance in trust is also a useful way of speeding up the playout if you pass away.
There are a wide range of trusts available, so it is a good idea to speak to a professional when arranging your life insurance. We have wide experience in these areas and so we can help you achieve your desired outcome.
The other factor to consider is that a lot could happen between you taking out your whole of life protection and any pay-out. If you’re in your 50s now, a lot could happen in the next four decades! For example, IHT could be abolished or reformed, meaning you could have paid a significant amount in premiums for cover you no longer need. This does need to be considered as a possible risk, although your beneficiaries would still benefit from the life insurance.
We’re here to help you arrange the right cover for your needs, and ensure the correct trusts are put in place to mitigate any IHT liability. If you’d like to discuss ways of minimising or potentially eliminating your likely Inheritance Tax bill, please get in touch.
Private Client Director
Paul has spent more than 25 years in the private wealth arena and joined HFMC Wealth in 2013. His well established and high-calibre team work both with families with generational wealth as well as with individual clients who are looking for bespoke financial plans.