Life insurance and estate planning to reduce inheritance tax

Life insurance often comes up during estate planning meetings, but are we always considering the advice we can give clients about these policies and how they fit into their wider estate planning journey?

Many clients see a life insurance policy as a way to create financial security for their family or to help cover an inheritance tax (IHT) liability. However, if not handled correctly, a life insurance payout can increase the value of an estate and lead to an unexpected or unnecessary IHT bill.

Understanding how life insurance integrates with estate planning – and how trusts can be used to hold these policies – can make a significant difference to a family’s financial future.

Benefits of life insurance policies

Life insurance is more than just a financial safety net for families; it’s a strategic estate planning instrument. A policy that pays out a lump sum on death can serve several key purposes:

1. Providing financial security for family

Most people take out life insurance to replace lost income or provide a financial cushion for dependants. The payout can help cover mortgage repayments, living expenses and education costs, ensuring loved ones aren’t financially burdened.

2. Paying inheritance tax or other liabilities

The perfect storm of rising property prices, strong investment performance and frozen IHT thresholds has created a situation where more families are being drawn into the IHT realm. In the tax year 2022-23, IHT revenue stood at £7bn and is forecast to rise to over £15bn by 2032-33, essentially doubling the revenue in 10 years.

This raises the question of how families will pay the bill, which is due within six months, as assets like property, trading businesses and agricultural land can’t usually be sold quickly. Life insurance is a useful way to cover this tax liability, preserving the estate’s value by ensuring assets don’t need to be sold quickly to raise funds.

For example, a ‘whole-of-life’ policy can be arranged to pay out a lump sum on death specifically to settle any IHT bill.

3. Equalising inheritances

Life insurance policies can help when an estate includes assets that are hard to divide between beneficiaries, such as a business or property. For example, if one beneficiary receives the asset, a policy can provide an equivalent benefit to other family members, helping avoid disputes and maintain fairness.

4. Supporting business succession

For business owners, life insurance is essential to fund a buyout of a deceased partner’s share or to ensure continuity of operations through a ‘key person’ policy.

Using trusts for life insurance policies

Writing a life insurance policy into a trust can enhance the effectiveness of estate planning by offering tax advantages and control over how the proceeds are distributed:

1. Keeping the payout outside the estate

When a life insurance policy is written in trust, the payout isn’t counted as part of the estate for IHT purposes. This means the funds can pass to beneficiaries free of tax.

It can also help with the estate planning of a surviving spouse or partner, as the lump sum won’t form part of their estate either – potentially reducing or eliminating an IHT bill on their death.

2. Faster access for beneficiaries

Proceeds from a policy held in trust are paid directly to the trustees, without having to wait for probate to be granted. This gives beneficiaries access to funds quickly – a crucial benefit if they need money for living expenses, funeral costs or to pay an IHT bill.

3. Greater control over distribution

A trust allows clients to specify who receives the funds, how much and when. For example, they may wish to delay access for young children until they reach a certain age, or ensure the money is used for education or maintenance purposes.

Trusts also help protect the payout from the circumstances of the intended beneficiaries, such as divorce, care needs or financial difficulty.

Conclusion

Life insurance is a useful tool in estate planning and should be part of our conversations with clients.

Placing a life insurance policy into a trust offers further benefits – keeping proceeds outside the taxable estate, providing faster access for beneficiaries and maintaining greater control over distribution.

Properly structured, life insurance provides both peace of mind and practical financial protection for families and forms an important part of our estate planning conversations.