Does obtaining life insurance help you avoid paying inheritance taxes?

In order to avoid future inheritance tax bills, an increasing number of people are purchasing life insurance

Does that make sense?

Could purchasing life insurance lessen the growing burden of inheritance tax (IHT) that hundreds of thousands of families in the UK are dealing with?

Financial advisors say it might be beneficial, but there are a number of disclaimers attached to their advice, one of which is that you might wind up paying more in total premiums than your family's final tax bill.

Sales of whole-life insurance policiesthe kind of coverage most appropriate for inheritance-tax planningare undoubtedly booming. A tax that was previously only paid by a wealthy minority is quickly becoming a problem for middle-class families who don't consider themselves particularly affluent, as evidenced by the fact that Britons spent 18% more on premiums for these policies last year than the year before.

Below, the article continues.

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Start your trial. According to the government, very few families pay inheritance tax at the moment. It is accurate to say that less than 5% of deaths in 2022 - 2023, the most recent tax year for which statistics are available, resulted in an inheritance tax charge. Only 31,500 households had to pay a bill. However, the numbers are expected to rise rapidly. According to the government's own estimates, 10% of deaths will result in an inheritance tax liability by the 2029 - 2030 tax year; in other words, it is anticipated that the number of families paying the tax will more than double in just seven years. According to the official forecast, inheritance tax receipts will increase to 14.5 billion by 2030 - 2031, which is 67% more than what the Treasury anticipates earning in the current fiscal year.

According to Shaun Moore, a tax and financial planning specialist at wealth management company Quilter, this trend is well under way. "IHT receipts for the 2025-2026 tax year reached 7.7 billion by the end of February, surpassing the 2023-2024 total of just under 7.5 billion with a month still to go," he says. "IHT is undoubtedly no longer a tax reserved for the extremely wealthy. The "

This is due to a few factors. First, since April 2009, the inheritance-tax thresholdthe estate size at which the tax becomes duehas been frozen. In order to provide additional headroom against the value of the family home, the then-Conservative government did implement an additional "residence nil-rate band" in 2017. However, this has also been frozen at 175,000 ever since. These freezes will last until at least April 2031, according to the current administration. As household incomes and asset prices rise, more people will unavoidably fall into the inheritance tax net. For instance, since April 2009, the average value of a house has increased by more than 70%.

Furthermore, the list of assets that contribute to the value of your estate for inheritance tax purposes has been expanded by the current government. Most importantly, starting in April 2027, any private pension funds you have in defined-contribution plans that remain at the time of your passing will be included in your estate. At the moment, inheritance tax is not applied to the majority of pension assets.

A portion of the inheritance-tax benefits offered to families are being reduced by the government. Its plans include a cap on the 100% business or agricultural relief applied when bequeathing businesses or farms; starting on April 6, you will only be able to pass on assets worth up to £2.5 million per person without paying taxes; any amount over this amount will be subject to 50% inheritance tax. A couple can still transfer £5 million in assets between them, though.

Purchasing life insurance is growing in popularity.

In light of this, many more families are understandably worried that they will eventually have to pay an inheritance tax bill and possibly a sizable charge. As a result, more families are making plans, and methods like purchasing life insurance are growing in popularity. According to Ian Dyall, head of estate planning at the wealth management company Evelyn Partners, "more families and their advisers are now reaching for the security of insuring against the IHT liability as the screw is being turned on reliefs and exemptions."

It's a fairly straightforward idea. The plan is to determine the amount of inheritance tax that your family will eventually be responsible for and then purchase a life insurance policy that will cover this amount. Term insurance is the most popular and basic kind of life insurance; if you pass away within the policy's term, it will pay out a set amount. This won't apply to an inheritance-tax liability, though, because there won't be a payout if you live past the policy's term because you can't predict when you will pass away. Rather, you usually need whole-life insurance, which will pay out when you pass away as long as you continue to pay the premiums.

It's also crucial that the policy be written inside a trust, which is a legal framework that guarantees the insurance proceeds don't end up in your estate. If not, the insurance payout may result in an extra inheritance tax obligation for your family. Although there might be costs associated with this service, the majority of advisors and insurers can assist you in structuring the coverage in this manner.

Everything is going well so far, but there are problems with whole-life coverage. First, it's critical to know how much the coverage will cost you now and in the future. Your age, health, and the size of the policy are all taken into account by insurers when determining your premiums, and you might need to have a medical examination. There are two types of coverage: guaranteed, where the initial premium is fixed, and reviewable, where the insurer has the authority to raise your premiums over time. The latter is typically more costly initially, but you can be sure that premiums will stay reasonable for as long as you require the coverage.

Premiums for a whole life can be expensive. According to Evelyn Partners, the monthly premium for a healthy 50-year-old customer looking for guaranteed coverage of £1.4 million would be about £1,250. Even though these are still substantial monthly payments, the client would need to live until the age of 143 in order to have paid more in premiums than the insurance payout. Additionally, the cost will be higher for older policyholders, especially as their health declines, and some may even find it difficult to obtain coverage. In certain situations, the total premiums paid will surpass the insured payout much sooner. Because of this, advisors frequently advise getting life insurance when you're youngerfor example, in your 50s or 60s.

In comparison, "we'd look at whole-of-life insurance as a young person's game," says Tom Mullard, Time Investments' business director for tax services. "You know what you're paying if you have guaranteed premiums, and you might even have investments that yield returns from which you can pay the premiums, preventing your capital from actually declining. "This does mean you'll probably have to pay the premiums for a longer period of time, but the good news is that costs may go down," Dyall continues. "As providers fight for market share in the expanding market, prices seem steady and, in some cases, are even declining. A "

Should I save the money instead?

However, some people doubt that whole-life insurance is a good value, especially for policyholders who are in good health and have many decades to live. Additionally, if you decide to change your mind after signing up for a policy and cancel the coverage, you will have wasted the money you have already spent. According to James Baxter, the founder of Tideway Wealth, a financial planning firm, it makes sense to consider these kinds of policies more like savings plans than insurance contracts. In essence, you are saving money every month until you have enough to cover a bill. Baxter contends that "people should make sure they understand these policies before signing as it could cost them more than they realise." "The effective return falls below risk-free rates if a couple purchases a policy at age 64 and one of them lives past 90, making the policy a less desirable savings option. The "

He is saying that by the time you are in your 90s, you will have paid so much in premiums that the amount your beneficiaries will receive back will be insignificant, if not negative. It would have been wiser for you to deposit the same sum of money each month into a building society savings account or a risk-free bank. This claim is refuted by the fact that regular savings would not be sufficient to cover an IHT liability and would not give many families the assurance they require. You cannot guarantee that you will live long enough to accumulate sufficient funds to pay the bill. However, if you decide to pursue insurance, it is imperative to minimize expenses. An independent broker can offer helpful assistance in this situation, but it's crucial to remember that insurance is not a panacea for IHT planning.

Crucially, you will require less insurance the more you can do to lower your family's IHT liability. This entails making sure you make the most of additional IHT planning opportunities. According to Lyall, "life insurance does not replace good planning; rather, it supports it by addressing the elements that planning cannot fully remove and by creating certainty." "The amount of life insurance needed decreases with improved underlying planning, and premiums become more affordable. A "

Utilize gifts to their fullest potential to lower inheritance taxes.

It is undoubtedly crucial to utilize all of your gift allowances in order to minimize the size of your estate. You are exempt from paying taxes on gifts up to £3,000 annually as well as numerous smaller gifts with a maximum value of £250 per recipient. Additionally, gifts for a family member's wedding or civil partnership are exempt from tax, as are gifts of any size given to charities. Income-based gifts can also be beneficial. You can donate as much of your regular monthly income as you like without facing tax repercussions if you can demonstrate that it exceeds your needs.

Additionally, think about making potentially exempt transfers, which are gifts that, for tax planning purposes, will not be included in the value of your estate as long as you survive for at least seven years after making them. Even the possibility of not living that long can be covered by insurance (see below).

In addition to gifting, expert advisors can assist you with other IHT planning techniques, such as maximizing business relief and utilizing investment vehicles like the enterprise investment scheme (EIS). Mullard continues, "The larger point is that planning has to start earlier." Even though you might only have 40 years left to live, it can be difficult to justify thinking about these problems, but doing so will make it simpler to find a comprehensive solution. A "

A few subtleties to think about.

Term assurance could help you deal with a more pressing problem, but whole-of-life coverage might be the best option for protecting against your family's potential inheritance tax (IHT) liability. Giving away substantial amounts or valuable assets will lower your estate's value for IHT purposes, which will lower your family's bill. However, these potentially exempt transfers only disappear from the IHT net seven years after you make them. If this is the case, a term assurance policy may protect you against passing away sooner than anticipated and incurring tax obligations. The plan is to only obtain the necessary insurance for a predetermined amount of time before your gift is completely free from IHT. Generally speaking, this is far less expensive than whole-life insurance.

Whether your gift qualifies for taper reliefwhich may be applicable if you pass away within seven years of making itis one subtlety to take into account. Many gifts are eligible for this after three years, with the IHT payable rate dropping from 32% at three to four years to 8% at six to seven years. If so, you can purchase a "decreasing term assurance" policy, which is less expensive and pays out a decreasing amount over the policy's term. Taper relief is only applicable if the total amount of gifts you give before passing away surpasses the 325,000 tax-free IHT threshold.