Qualifying Life Policies
An individual may take out a whole of life policy on his own life which pays a cash lump sum on death whenever this occurs; alternatively, an individual may take out a fixed term assurance policy, again on his own life, which pays out a cash lump sum but only if the individual dies within the fixed term of the policy (if the individual survives the fixed term the policy lapses and nothing is paid out).
A term assurance policy is a particularly attractive cost effective option, for example, for a married man with children to cover the period whilst his outgoings/costs (e.g. school fees) are highest; this may be the period until the children are aged 18 (thus a 20 year term policy may be appropriate).
The above categories of policy are “qualifying policies” for tax purposes. A qualifying policy is one where income tax relief is available (i.e. tax relief of 12.5% of the premium) with respect to the premium payments but only if the policy satisfies certain conditions including being issued pre 14th March 1984; thus, policies issued on or after this date do not qualify for income tax relief on the premiums.
Inheritance Tax (IHT)
However, perhaps more importantly, the proceeds of a qualifying policy (irrespective of the date of issue) are subject to neither income tax nor capital gains tax (CGT), although an inheritance tax (IHT) charge may arise on the proceeds, as such proceeds will form part of the deceased’s estate on death.
To avoid this IHT charge it is often advisable for the policy to be placed in trust (e.g. a discretionary trust) for the benefit of, say, the surviving spouse and/or children. The proceeds payable on death then no longer form part of the deceased’s estate and no IHT charge arises thereon.
Although IHT is in general payable on death, it may also arise where an individual makes a gift to another individual (a so-called potentially exempt transfer or PET) and the individual making the gift dies within seven years of making it; the liability is that of the recipient of the gift, not the person making it.
In order to protect himself from such a charge the recipient could take out a seven year term assurance policy on the life of the individual making the gift for a sum assured of the amount of the IHT charge; the policy proceeds could then be used to discharge any IHT liability arising.
Non-Qualifying Life Policies
Life assurance policies may also be used as a form of investment, rather than as a mechanism to provide financial protection in the event of death; such policies are invariably non-qualifying policies.
A non-qualifying policy provides no income tax relief with respect to the premium payments and any proceeds are subject to income tax at the individual’s marginal rate of income tax.
The classic non-qualifying policy is the single premium bond; a single premium is paid on inception of the policy and the bond’s value reflects the value of the life office’s underlying investments. Such policies are often taken out with a life office based outside of the UK (typically, the Isle of Man) rather than one based in the UK; the reason is the relatively “tax free” environment of the Isle of Man which allows a greater and quicker build up in the bond’s underlying worth.
No tax liability arises until the policy matures or is surrendered, and this permits higher or additional rate taxpayers to roll-up the investment income arising on the policy effectively tax-free.
Furthermore, a unique attraction of such policies is that up to 5% of the initial premium may be withdrawn each year without at that time precipitating any tax charge, thus permitting interim tax-free enjoyment of any growth in the value of the policy; any charge only arising as and when the policy eventually matures or is surrendered.
In view of the fact that the value of non-qualifying (unlike qualifying) life policies may go down as well as up, they are primarily an investment for individuals who can afford to take such a gamble.
By Malcolm Finney
This article was first printed in Tax Insider in February 2011.