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Many years ago the combination of the purchase of an annuity and the taking out of life insurance written in favour of the next generation or the surviving partner was regarded as a good procedure, both for investment purposes and estate planning.
Many years ago the combination of the purchase of an annuity and the taking out of life insurance written in favour of the next generation or the surviving partner was regarded as a good procedure, both for investment purposes and estate planning.
Are such arrangements still valid and beneficial under the current tax régime and investment conditions? Presumably the income element of the annuity must qualify as being available for 'gifts out of income' inheritance tax exemption, whilst the capital element of the annuity replaces the lost income from the reinvestment.
(Query T15,852) – Testator.
It will be recalled that, in essence, such back-to-back schemes involve the purchase of an annuity for the duration of the taxpayer's life. Having done so, in order to replace the capital used by the taxpayer to purchase the annuity, the taxpayer effects a whole life policy on his own life, which he puts in trust for his heirs, under which the original capital sum (plus bonuses) will be payable on his death. The taxpayer has thereby provided himself with a source of income from which, among other things, he can fund the ongoing insurance premiums, whilst also effectively removing the capital cost of the annuity from his estate, but still providing an inheritance tax-free inheritable 'pot' for his beneficiaries.
Such arrangements face two areas of difficulty as effective estate planning measures. In the first instance section 263, Inheritance Tax Act 1984 applies in the event that the taking out of the two policies are associated operations, and deems the taxpayer to have made a transfer of value at the time the life policy became held in trust equal to the lower of the total consideration paid for the annuity and the life policy and the value of the greatest benefit capable of being conferred by the life policy. The latter part of the formula is capable of quantification for non-profit life policies but problems arise in the case of with-profit, and equity and unit linked policies. However, in practice section 263 is not applied provided that the life policy was issued on full medical evidence of the assured's health and would have been issued on the same terms if the annuity had not been purchased at the same time (Statement of Practice E4). The easiest way to demonstrate that the two contracts were not 'associated' would be to take up the annuity and the life policy with separate life offices. If the same life office is used, it is vital for the life policy to have been issued and the premiums fixed on the basis of full medical evidence.
The other major drawback in terms of the estate planning efficacy of these arrangements is that the capital element of the annuity is not regarded as income for the normal expenditure exemption (section 21(2) and (3), Inheritance Tax Act 1984). The taxpayer is therefore faced with the impracticalities of establishing a modus vivandi under which liabilities are paid out of capital leaving surplus income available for the normal expenditure exemption.
It should be noted that the back-to-back arrangements contemplate a purchased life annuity. The anti-avoidance rules do not apply where the individual becomes entitled to a pension annuity under an approved occupational pension scheme, personal pension scheme or self-employed retirement annuity arrangement. In these cases the whole of the pension instalments are subject to income tax (there is no untaxed 'capital content' proportion as with a purchased annuity) with the result that the individual is free to regard the whole of his pension income as available (over and above his living expenses) for normal income exempted gifts, so providing a useful opportunity to effect an inheritance tax-free policy in trust for his beneficiaries. – Digby Bew.
In principle the combination of a purchased annuity and the taking out of a life insurance policy written in trust in favour of the next generation still works as an estate planning tool. However, whether atrocious annuity rates and current investment performance still allow the combination to work in practice, I do not know. Someone from the industry would need to answer that one.
It is crucial to the combination that both the annuity and the life policy are underwritten on a regular basis with no subsidy of one by the other. The best protection is to take the annuity and life policy from different life companies.
The annuity payments will be part capital and part income. Only the income element will suffer income tax. Only the income element is eligible for the 'normal expenditure out of income' exemption when part of the annuity receipts are applied as premium payments. The capital element could be used to fund the premium payments if the £3,000 annual exemption were available.
Whether the combination still works in practice depends principally upon the level of cover which can be achieved. The capital sum paid for the annuity is immediately put out of the taxpayer's estate, as the purchase is not a transfer of value.
Upon the assumption that the capital used to buy the annuity would have suffered inheritance tax, one can regard the net cost of the annuity as 60 per cent. If necessary the level of life cover achievable can be judged against that. – Robin Hood.
