Life insurance and inheritance tax planning: protecting the legacy you want to leave

When it comes to planning for an IHT liability, the first question to ask yourself is, ‘what is my motivation?’

Our clients often tell us they are focussed on simply not wanting to pay IHT. This is understandable, given the tax they’ve already paid while building their wealth. However, when we dig a bit deeper, what many people really want is to pass on as much of their wealth as possible to their loved ones. That means inheritance tax planning should usually sit within a broader conversation about passing on your wealth - who you want to benefit, when you want them to receive support and how much control or flexibility you want to retain.

It is also worth thinking carefully about how that wealth would actually be passed on. Many estates are of significant overall value but have relatively little accessible cash. Investment portfolios, property, pensions and business interests can all create value, but they may not provide liquidity at the exact point the estate needs it.

Pensions are also becoming more relevant. From 6 April 2027, most unused pension funds and pension death benefits will be brought within an individual’s estate for IHT purposes - a change we explain in more detail in our article on the 2027 pension inheritance tax changes. The new rules mean that inheritance tax linked to pension assets may be paid directly from the pension itself, reducing the amount ultimately received by beneficiaries. For some families, this could mean a significant, and sometimes unexpected, reduction in the wealth that reaches the next generation.

That is where life insurance can be valuable. Used well, it can create a dedicated source of capital for your beneficiaries, helping to bridge the gap between what an estate is worth and the cash available to settle tax, administration costs or other liabilities.

What is life insurance?

Life insurance, often referred to as life assurance when cover is designed to last for life, is a policy that pays a specified amount when the person covered dies, subject to its terms and conditions.

Whole of life assurance provides cover for life, provided the premiums continue and the policy terms are met.

Term assurance provides cover for a specified period, for example until age 75, 80 or 85.

The question is not simply which type of policy is better. Rather, it’s ‘how much capital needs protecting and for how long?’

Do you pay tax on a life insurance payout?

In the UK, life insurance payouts are generally not subject to income tax or capital gains tax. However, they can be subject to IHT if the payout forms part of the deceased’s estate. A policy can therefore be written into an appropriate trust, so the proceeds are held for the intended beneficiaries rather than becoming part of the estate. 

Subject to the policy and trust arrangements, proceeds can often be paid to trustees without waiting for probate, creating a separate source of capital while other assets are being dealt with.

Life insurance to cover inheritance tax

Can life insurance be used to pay IHT?

Yes, life insurance can be used to help pay IHT.

Rather than reducing the tax itself, life assurance creates a pool of capital that can be used to meet an IHT liability. This can help avoid the need to sell assets simply to raise cash and protect more of the wealth ultimately passed on to your family.

For example, if £1m of estate value were ultimately exposed to IHT at 40%, the tax attributable to that capital could be £400,000, before considering the wider estate and available exemptions, allowances and reliefs. A £400,000 life assurance policy could provide £400,000 of additional capital for the beneficiaries. Rather than only asking, ‘how much IHT can I save?’, we can also ask, ‘how much do I want to make sure my family receives?’

How much life insurance do I need to cover inheritance tax?

The amount of life insurance needed to cover inheritance tax depends on the size and structure of your estate, available allowances and reliefs, who you plan to leave assets to and how much liquidity your beneficiaries may need. A useful starting point is to estimate your potential IHT liability, then decide whether you want cover for all of it or only the part that may be difficult to fund from cash or other liquid assets.

For many families, this means looking beyond headline estate value and asking practical questions: which assets would your beneficiaries want to keep, how quickly would cash be needed and what could change if pensions, property, investments or business interests form a larger share of the estate?

Is a life insurance policy part of an estate?

This depends on how the policy is structured. In many cases, the proceeds can be kept outside the policyholder's estate for the benefit of the intended beneficiaries. This can also create a useful source of liquidity while investments, pensions, property or business interests are being valued or administered.

What does life assurance cost?

The cost will depend on factors including your age, health, the amount of cover required and how long the protection needs to last. Whole of life assurance will normally cost more than equivalent term assurance because it provides lifelong cover. Term assurance will generally cost less because it provides protection for a defined period rather than for life.

Rather than viewing the premium simply as another monthly cost, it can be more useful to consider it in the context of the capital being protected. At Canaccord Wealth, we will help you decide whether the premium is worth paying based on your estate, your likely IHT exposure and what the policy is intended to achieve.

For example, take an illustrative couple, both aged 60, non-smokers and in standard health. If £1m of their estate were exposed to an eventual 40% IHT charge, the potential liability could be £400,000. A joint life, second death policy with guaranteed premiums providing £400,000 of cover could cost approximately £440 per month for whole of life assurance, equivalent to around 0.53% a year of the £1m being protected. Alternatively, term assurance to age 85 could cost approximately £119 per month, equivalent to around 0.14% a year*.

Whole of life assurance provides long-term certainty. Term assurance provides protection for a fixed period at a lower cost. The better question may not be, ‘is £440 a month expensive?’ It may be, ‘is protecting £1m of family wealth for around 0.5% a year worthwhile?’

Health and life expectancy also affect the value of cover. Someone in good health may pay premiums for many years before the total cost approaches the eventual payout. Those with health conditions may face higher premiums, meaning the total cost can build up more quickly.

Does IHT still have to be paid with assurance in place?

If your estate exceeds the IHT threshold, then IHT must be paid, whether you have life assurance in place or not.

The benefit is that, where the policy is appropriately written in trust, the life assurance proceeds can be used, if needed, to help meet the IHT cost and protect the value ultimately reaching your family. This can be especially useful where the alternative would be selling or restructuring assets simply to raise cash.

How life insurance works as part of estate planning

Life assurance should not begin with choosing a product. We first establish what you want your legacy to achieve, model how your estate could develop and identify the potential IHT and liquidity gap. From there, we can consider how much of that risk should be protected, for how long and whether term assurance, whole of life assurance or a combination is most appropriate.

We also use cashflow analysis to test whether premiums remain affordable alongside retirement spending, gifting, future care needs and your other long-term objectives.

This makes life insurance especially relevant for estates where the main concern is not just the size of the IHT bill, but when it has to be paid and whether beneficiaries would otherwise need to sell long-term assets at the wrong time.

Key advantages of using life assurance to help manage IHT include:

• You can retain control and flexibility: Life assurance can help you retain capital you may need for your own lifestyle, retirement or future care, while providing protection as your longer-term position becomes clearer. This can avoid forcing decisions around gifting, trusts, asset sales or restructuring before you are ready
• It can be immediately effective: Subject to the policy terms, life assurance can provide protection from the outset. Other IHT planning approaches can take time before their intended estate planning benefits are fully achieved
• Funds can often be available before probate: Where a policy is appropriately written in a trust, proceeds can often be paid to the trustees without waiting for probate on the wider estate. This can give beneficiaries a practical source of capital when other assets may take longer to access
• It provides valuable liquidity: This can be important where an estate is asset-rich but cash-poor, helping beneficiaries meet liabilities without being forced into quick decisions about investments, property, pensions or business interests. For an investment portfolio, that can mean avoiding forced sales at an unfavourable point in markets and allowing the portfolio to remain positioned according to its long-term investment strategy. The cover is not simply helping to protect the value of the estate. It can help protect the strategy too
• It can support considered decisions around business interests: Where a family owns a business, life assurance can provide liquidity outside the company, giving the family and advisers more time to think through ownership, succession or a future sale and protect the value of the business
• Premiums can potentially be IHT-efficient: Depending on the circumstances, premiums may fall within available gifting exemptions, including the annual exemption or normal expenditure out of income exemption
• Inflation-linked increases can be included: This is when the sum assured is increased annually in line with inflation to allow for increases in the value of your estate without further medical underwriting.

What else do I need to know about life assurance?

Life assurance is medically underwritten, so your age, health and lifestyle will affect the availability and cost of cover. Even so, cover may still be available where clients initially assume it will not be.

There are important differences between policy types. With term assurance, if you survive beyond the end of the term there will normally be no payout. With whole of life assurance, premiums may be payable for many years, so affordability over the long-term matters.

Life assurance should therefore sit within a wider strategy. Depending on your circumstances, this may also include gifting, trust planning, changes to how assets are used or owned and investing strategies.

It is also important to understand the policy terms. Some policies allow premiums to be increased by the provider, even if the sum assured stays the same.

At Canaccord Wealth, we tend to favour guaranteed premiums so the agreed cost does not later increase simply because you have become older or your health has changed. Our estate planning advice also includes comprehensive cashflow forecasting, allowing us to test affordability in the context of your wider plan.

Regular reviews are important. Investments change in value. Businesses are sold. Property is bought or disposed of. Pensions are spent. Gifts are made. Families evolve and legislation changes. A good legacy plan should evolve too.

Is life assurance right for me?

When you are thinking about estate planning, the most important question is not which product to use. It is what practical and meaningful outcome you want to achieve.

A good Wealth Planner should start with your needs and objectives, not the solution. How much wealth do you need to retain? What do you want your family to receive? How much certainty do you want to create? Which assets would you want them to keep? Importantly: if you died tomorrow, where would the cash actually come from?

For some people, whole of life assurance can create a defined pool of capital for their family. For others, term assurance can provide cost-effective protection while their longer-term position develops. In many cases, life assurance will sit alongside other planning as part of a broader legacy strategy, helping to balance financial security, tax efficiency, liquidity, flexibility and the wealth ultimately passed to the next generation.

* Premium figures are illustrative only and based on a joint life, second death policy for an illustrative couple both aged 60, non-smokers and in standard health, with guaranteed premiums and £400,000 of cover. Actual premiums and availability will depend on individual circumstances and medical underwriting.