Take out life insurance to mitigate inheritance tax (IHT) on pensions
3rd October 2025
Posted in Articles, IHT, Inheritance Tax, Trusts and Estates by Forbes Dawson
From 6 April 2027 (if nothing changes) pension funds will be subject to 40% inheritance tax (IHT). Previously pensions were generally outside a person’s estate and were therefore treated as ‘funds of last resort’ for IHT planning purposes. This means that many people will be brought into the IHT net who were not in it previously, and many wealthy individuals will have a much bigger IHT headache than before.
‘Whole of life insurance’ (WOLI) pays out a set amount of cash on death if the policy holder pays a monthly premium. The terms will typically be based on the age and health of the individual, but anecdotally I have heard about some surprisingly low premiums being offered. A WOLI could be used to potentially improve the IHT liability on a pension by using (taxable) pension income to fund the insurance premiums and also by ensuring that the life insurance policy is held in trust so that any payout is not itself within the scope of IHT on death.
Example
Roger is 78 and Jan is 80 and they have £1.25m worth of pension schemes between them which they are ultimately planning to leave for the benefit of their son. They explore taking out a life insurance policy which pays out £500,000 on second death and are quoted £3,200 per month (£38,400 per annum) for this policy. They calculate that they will have to withdraw £48,000 from the pension scheme to leave them with £38,400 to pay the premiums (based on a 20% income tax rate). They then model various second death scenarios which at each point measure the value of the pension scheme under various scenarios:
Scenario one: Leave the pension untouched and do not take out life insurance.
Scenario two: Take out life insurance (in trust) and use the pension to fund premiums.
They are surprised to see how under almost all scenarios their son will end up inheriting more under Scenario two. This is because of a combination of seemingly generous premiums, the IHT-free insurance payout and the fact that the pension growth (which will be taxed at 40%) is curtailed by the withdrawals.
Forbes Dawson view
Everyone with a significant untouched pension pot should at least undertake the modelling exercise done by Roger and Jan above with a financial adviser. Various assumptions would need to be made (most notably investment growth) and insurance quotes would need to be sought but from anecdotal evidence we would expect (for anyone in good health) the ‘life insurance route’ to show significant advantages compared to simply letting the pension scheme grow to be hit with an IHT charge on second death. Life insurance can be useful for other IHT liabilities too and it may be a rare case of both the house and the gambler having an edge, because any premiums effectively come with a 40% discount due to the decreased IHT bill, whereas any payout on death, if structured properly, will escape IHT. The main obstacle to doing this kind of planning is often an emotional reluctance to part with premiums now, for a payout that will only be realised after death.
