How a life insurance could protect your estate from IHT

One way to do this is to use life insurance, funded by pension income, to create a lump sum for beneficiaries on death.

Life insurance is a contract between an insurance company and a policyholder. In exchange for a premium, the insurance company agrees to pay out, usually in the form of a lump sum, following the policyholder's death.

Purchasing life insurance for IHT purposes

Pairing life insurance and pensions can be an effective way to manage Inheritance Tax (IHT) liabilities. This can be structured as follows:

Buying an annuity with your pension fund

• The pension holder buys an annuity with their pension funds, providing a guaranteed level of pension income for life.

Buying Whole of Life insurance

• After allowing for the Income Tax due on that pension income, they seek a Whole of Life insurance contract with premiums at the same level as the net annuity income. The level of premiums will determine a guaranteed sum assured (i.e. the value paid on death).
• The Whole of Life policy is usually placed in a trust so the eventual proceeds are not paid into the estate and are therefore not subject to IHT.
• Insurance premiums are simply paid from the net annuity income throughout life.
• On death, the insurance company will pay the guaranteed sum set at outset into the trust. This sum assured suffers no tax on payment and can be immediately paid out to beneficiaries without tax.
• Alternatively, the funds can be retained in the trust if the family want the flexibility and protective elements of an ongoing trust arrangement. 

How this works in practice - a 74-year-old individual

This individual effectively converts their £1m pension fund, which will suffer IHT and Income Tax under the new rules, into a £1.514m lump sum for their beneficiaries.

Working on the basis that the £1m pension fund would suffer IHT at 40% and Income Tax at 20% in the hands of the beneficiaries, the net value of the £1m pension is £480k. Naturally the net value could be worse than this if their beneficiaries are higher rate taxpayers and/or the pension fund would lead to the loss of some RNRB on death.

This type of planning effectively converts £480k into £1.514m for the beneficiaries.

Naturally, this sounds quite attractive - perhaps too good to be true - but this planning effectively ties up capital for an unknown period (the rest of life) therefore the £1m is not achieving investment growth during that period. As such, you must consider what the effective annualised return is and how this changes the longer you live:

Note – the figures used in the above example are taken from annuity and Whole of Life insurance research undertaken in January 2025. All quotes are obtained on standard underwriting terms.

Other strategies for pairing pension funds with life insurance

The above represents the most straightforward way to match pension funds with life insurance. However, there are several other potential strategies:

Utilising drawdown instead of annuitisation

Instead of handing over a pension fund to an annuity provider, individuals could choose to retain the pension fund and pay the insurance premiums via income drawdown. They will retain full control and access to the pension funds, but there is significant risk with this strategy. If a required level of investment growth is not achieved with the pension funds, the fund could be fully depleted before death and jeopardise the ability to continue paying the insurance premiums. 

Shorter-term insurance contracts

Individuals may now choose to rely on their pension funds for their needs and gift away other assets to help mitigate their IHT liability. Pension funds could be used to fund short-term life insurance contracts (typically seven-year term policies) to protect against the risk of dying after making such larger gifts. Shorter-term annuity contracts could be used here to fund the associated premiums.

This shorter-term planning may work well for business and land owners considering significant gifts in light of changes to Business Relief (BR) and Agricultural Property Relief (APR).

The importance of health

When considering life insurance and annuity options, health is key. Better health usually means more affordable insurance. However, those in ill health can still use this planning. While insurance may cost more, a medically underwritten annuity often provides higher income, potentially covering the extra cost.

If insurance isn't available due to significant health issues, other IHT planning routes will need to be considered.

Key points to consider

• Align the terms of the annuity and insurance contract.
• Carefully consider the trust holding the life insurance policy.
• Note that insurance premiums may be considered Chargeable Lifetime Transfers and may be subject to in-life taxation.
• Remember to seek appropriate advice to ensure your arrangements are fit for purpose.

Insurance can play a key role in transferring wealth to future generations however this planning is best for those who do not need to use their pension assets. If you rely on your pension, this may planning not be suitable.

Furthermore, other options such as drawing income and gifting it under the Gifts out of Surplus Income exemption (Normal Expenditure Gifting), may be more attractive for those who want their beneficiaries to enjoy the funds in the shorter term.

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