A prefunded Inheritance Tax Trust – Life Insurance and Inheritance Tax on Pensions: A Planning Opportunity

From 6 April 2027, if nothing changes, pension funds will fall within the scope of Inheritance Tax (IHT) at 40%. Historically, pensions were outside a person’s estate and often treated as “funds of last resort” for IHT planning. This shift means many families will face an unexpected tax burden, and for those with significant pension pots, the challenge could be substantial.

Why This Matters

If you’ve worked hard to build a pension with the intention of passing it on, the idea of losing 40% to tax is frustrating. But there are strategies to mitigate this, and one worth considering is Whole of Life Insurance (WOL).

How Whole of Life Insurance Works

A WOL policy pays out a fixed sum on death, provided premiums are maintained. Premiums depend on age and health, but surprisingly competitive rates are available. The key is to hold the policy in trust, so the pay-out falls outside your estate and escapes IHT.

A Practical Example

Roger (79) and Jan (78) have £1.25m in pensions they plan to leave to their son. They explore a WOL policy paying £500,000 on second death, quoted at £1,082 per month (£13,977 annually). To fund this, they withdraw £16,250 from their pension (assuming 20% income tax), leaving £13,000 for premiums.  The gross income yield on the pension is just 2.6%

They model two scenarios:

• Scenario 1: Leave the pension untouched.
• Scenario 2: Take out life insurance (in trust) and use pension withdrawals to pay premiums.

Under almost all projections, their son inherits more under Scenario 2. Why? The IHT-free insurance pay-out and reduced pension growth (which would otherwise attract 40% tax) combine to create a better outcome.

Why Consider This Now

For anyone with a sizeable pension pot, running the numbers with Lexington Wealth is essential. Assumptions like investment growth and insurance quotes matter, but evidence suggests this approach can significantly reduce IHT exposure. Premiums effectively come with a 40% “discount” because they reduce the taxable estate, and the pay-out, if structured correctly, escapes IHT entirely.

The biggest hurdle? Emotional reluctance to pay premiums now for a benefit realised after death. But for those focused on legacy planning, this could be a smart move.

If you would like to discuss this further or have any questions, please do reach out to the team – we will be happy to help.