Insure against tax

Life assurance is perhaps the easiest but most underrated way of addressing an inheritance tax (IHT) liability. The principle is that you insure yourself for the amount of inheritance tax likely to be payable, with the policy held under trust. Through this arrangement, the heirs on death receive tax-free funds for the tax bill without the need to wait for probate.

With full cover from the very first premium, those who die earlier will have had good value. For those who enjoy an average or longer lifespan, life assurance might not save anything, because the premiums over the years can amount to paying the tax in another way.

These two sides of the coin are not the whole story however. The use of life cover can work best when combined with more careful planning, as a recent case demonstrates.

Our client has assets of approximately £2.7m with a liability of roughly £856,000. The client had already taken steps to address the problem with some life assurance under trust, which would be available to the children to help pay the IHT.

The existing cover is for £250,000, and we recommended an additional £600,000. Subject to underwriting, the cost would be £2,700 a month. The new policy will also be held in trust to avoid the proceeds themselves being taxed; the premiums aren't taxable due to the Normal Expenditure out of Income exemption.

That £850,000 of cover takes care of the immediate concern, but it's possible to do better by gradually reducing the amount of tax due.

Using the new facility to hold AIM shares within an ISA gave a potential IHT saving of £63,000 after two years. The client's share portfolio is substantial, but there would be an undesirable capital gains tax bill on disposal, which would include gifting it.

Fortunately there's an option to gift the capital and sidestep the tax. We recommended gifting the shares to a discretionary trust and claiming holdover relief, which defers the tax until a later sale by the trustees (or by the ultimate beneficiaries, possibly at a lower rate).

Taking into account the client's previous gift history, she could transfer £295,000 to the trust, putting that amount on the 'seven year tax clock'; a potential saving of £118,000. After seven years, the exercise could be repeated when the seven year clock has expired. The combination of these three strategies come together to give the following savings to our client's family - see chart below.

The red bar for the life assurance declines due to the premiums gradually eroding the benefit to the client. However this is offset by the AIM shares (within the ISAs) becoming exempt after two years and the holdover relief trust after seven years.

In addition, the chart shows the impact of growth on the AIM shares and the holdover trust being outside the client's estate. Overall regardless of the when the client was to die, the family would save approximately £600,000 as a result of the combination of life assurance and inheritance tax planning. 

Scott Gallacher is a director at Rowley Turton

He writes the regular IFA comment in Private Client Adviser