For many people, the most straightforward solution to an inheritance tax liability is to take out an insurance policy. This policy will be written into a trust so that when the person dies, their family will have enough money to be able to pay the tax bill. This post explains how these insurance policies work in practice.
Why consider inheritance tax insurance?
If your estate is worth more than £325,000 your relatives could be liable to pay inheritance tax on the amount over this figure when you die. Since this is levied at 40%, many people are keen to avoid this.
There are many ways that you can avoid paying inheritance tax, but another way is simply to fund for the liability. Inheritance tax insurance seeks to put enough money aside to pay the tax bill when you die. And always remember that the tax must be paid before the rest of the estate can be distributed.
How does this work in practice?
When you have worked out how much tax there is to pay on your death, you can simply take out an insurance plan to provide this amount on your death. Usually, the most appropriate type of insurance is a whole of life policy. As it sounds, this plan will run for the whole of your life. This is of course because you do not know when you are
going to die!
Single life or joint life?
If you are single or unmarried then you need to take out a policy on your own life for your own liability. However, if you are married, then you can use an exemption to pass all your assets tax-free to your spouse on your death. While
this avoids tax to begin with, the second person to die will end up paying more tax.
If this applies to you, then you need to take out a plan which pays out on the second death, when the tax becomes due.
Remember to take into account all the assets of both spouses.
Trusts
This is a complicated area and would require advice. You should write your plan into a trust for your family so that any proceeds from the policy go directly to your beneficiaries, and do not form part of your estate for tax purposes.
How does whole of life cover work?
You can pay for your insurance monthly, annually, or as an initial lump sum. Your payments usually go towards building up a pot of money, which is used to buy your cover. Therefore the plan depends on how well your investment performs. If it does well, you could expect cheaper premiums, and if it performs poorly your costs will rise.
The plan would normally be reviewed at a set interval, say every 5 or 10 years. At this time the costs would be reviewed.
Different types of whole of life plan
The choice is then one of the following options:
Maximum cover
This will be the cheapest form of cover. The premiums are set out to be low at the outset. However, this will mean that they will be extremely likely to increase in the future at the plan review.
Balanced cover
This cover will be more expensive as the premiums will be set at a realistic level so that at the plan review they are much less likely to increase, although if the plan performs badly this may happen.
Guaranteed cover
This is the most secure cover, as premiums are guaranteed never to rise; of course, this means that this is likely to
be the most expensive option.
Is cover expensive?
Unfortunately it can be. If you think about it, if you carry on paying premiums, the policy is guaranteed to pay out what could be a large lump sum. Therefore the costs can be high. Remember that family members can pay the premiums.
How is the cost calculated?
This will depend on your age, sex, the amount of cover and other factors.
The need for advice
Of course, this is a very complicated area, and there are major differences between the plans on the market. Therefore, we always recommend that you seek advice before taking action in this area. There are many other options to consider when planning to save on inheritance tax, and insurance is only one of these.
Dan Woodruff is a Certified Financial Planner based in Colchester, Essex, UK. He regularly writes articles on financial planning and investments aimed at UK business owners and investors. Go to http://www.woodruff-fp.co.uk to find more content, or sign up for his free newsletter or financial planning blog.
Woodruff Financial Planning is authorised and regulated by the Financial Services Authority.
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