How life cover could help your loved ones pay an Inheritance Tax bill

There’s a good chance you’ve already given plenty of thought to who will receive your estate when you pass away. You may have carefully considered which assets will pass to your children and grandchildren and how best to ensure that your legacy supports their future goals.

Though, one element you might not have fully factored into your plans is Inheritance Tax (IHT). It’s essential to understand how the UK’s “most-hated tax” could affect your estate and, ultimately, how much of your wealth will actually reach your beneficiaries.

This is especially important given the changes announced in the Autumn Budget last year.

As you might have seen in our Budget update, the chancellor, Rachel Reeves, decided to close the “loophole” that allowed pensions to fall outside of the IHT bracket.

So, from 6 April 2027, unused pension funds and death benefits payable from a pension could count as part of your estate for IHT purposes.

According to Sky News, this could result in almost 153,000 additional estates becoming subject to IHT.

What’s more, the IHT nil-rate bands – which you’ll read more about later – have been frozen until 2030, which may pull more estates over the threshold, too.

Due to these elements, it’s more important than ever to have a clear plan regarding IHT, and one option you may want to consider is using life cover to help loved ones manage a potential bill.

Continue reading to find out how.

Inheritance Tax is a levy charged on estates that exceed key thresholds

The amount of IHT your beneficiaries might pay – or whether they pay it at all – depends on the total value of your estate. This includes your property, savings, investments, and, from April 2027, your unused pensions.

The standard rate of IHT is 40%, but before your loved ones pay it, they can benefit from several tax-free thresholds:

• For the 2024/25 tax year, and set to remain so until 2030, the “nil-rate band” means you can pass on up to £325,000 without facing IHT.

• Additionally, if you leave your primary home to a direct descendant – such as a child, stepchild, or grandchild – you can make use of the “residence nil-rate band”, adding a further £175,000 to your tax-free sum.

• Combined, this means you can typically pass on up to £500,000 before IHT is due.

• For married couples or those in a civil partnership, any unused allowance can also be passed on to a surviving spouse when you die, effectively doubling your tax-free threshold to £1 million.

While this might sound like a substantial amount, when you consider the value of your home, along with other savings, pensions (as of 2027) and investments, you might find that you’re much closer to the total threshold than you initially realised.

There is another key exception to these rules: if your estate is valued above £2 million, the residence nil-rate band is gradually reduced by £1 for every £2 above this figure. As a result, the additional allowance is essentially tapered off entirely if your estate exceeds £2.35 million – or £2.7 million for couples. If your estate is very large, it’s worth speaking to an expert about mitigating IHT in advance.

Your loved ones could use your life insurance payout to manage an Inheritance Tax bill

You may have already considered various strategies for reducing a potential IHT bill, such as giving wealth away during your lifetime, or even leaving money to charity in your will (which our previous article covers in more detail).

However, one method you may have overlooked is using life cover.

This is a form of protection that provides your beneficiaries with a lump sum if you pass away within the policy term, perhaps helping them to maintain their standard of living after you’re gone.

If your estate is likely to exceed the IHT thresholds, life cover could also help your family pay off an unwanted tax bill.

It’s vital to write your life cover into a trust so a payout doesn’t fall within your estate

Be aware that a life insurance payout could form part of your estate, and be taxed, if you don’t take the appropriate steps.

Write your life insurance into trust and avoid an IHT burden

Firstly, it’s crucial to take out whole-of-life cover if you want to improve the chances of a payout and use it to cover an IHT bill. Otherwise, the cover could lapse before you pass away.

Then, to protect the policy from becoming part of your estate, you would need to write it into a trust. This is essentially a legal arrangement that lets you appoint trustees to look after the life cover policy on your behalf.

When the policy is written into the trust, the payout usually goes directly to your loved ones rather than forming part of your estate, meaning it’s typically exempt from IHT.

Additional benefits

There are other benefits of doing so.

• A trust can give you greater control over the life cover, helping to ensure that the money goes to the right people, which is especially practical if you’re not married or in a civil partnership.

• Since the payout typically bypasses probate – the legal process of sorting out your estate – your beneficiaries could receive the funds much more quickly, allowing them to settle an IHT bill without delay. This could be especially important now because, as reported by IFA Magazine, probate delays have surged since 2020.

Our team can talk you through any of the above topics in detail.

Before setting up a trust, you may want to speak to a financial planner

There are many different rules surrounding trusts, making them somewhat complex to set up and manage.

As such, it might be wise to speak to a financial planner before you write any life cover into one.

We could help you decide on the proper levels of cover for your unique situation and guide you through the process of placing the policy into a trust.

This could help you feel confident that your family won’t face additional financial stress at an already difficult time.

If you’re looking for invaluable support managing a potential IHT liability on your estate, email info@athertonyork.co.uk or call us on 0208 882 2979 to learn more.

Please note

This article is for general information only and does not constitute advice. The information is aimed at retail clients only.

All information is correct at the time of writing and is subject to change in the future.

Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.

The Financial Conduct Authority does not regulate estate planning, tax planning, trusts, or will writing.

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance. 

The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts. 

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.

Cover is subject to terms and conditions and may have exclusions.