How to Use a Discounted Gift Trust to Fund a Life Insurance Policy and Reduce Inheritance Tax

Chris Broome – Chartered Financial Planner

When planning your estate, it’s essential to strike the right balance between providing for your loved ones and managing the potential impact of inheritance tax (IHT).

A Discounted Gift Trust (DGT) is a powerful tool that can reduce your estate’s taxable value while also providing you with a lifetime income. Combined with a whole-of-life insurance policy, this strategy can further ensure your beneficiaries are not burdened by a hefty IHT bill.

Here’s how it works.

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What is a Discounted Gift Trust (DGT)?

A DGT allows you to gift a lump sum into a trust for your beneficiaries while retaining the right to a fixed, regular income for life. This creates an immediate reduction in the taxable value of your estate, thanks to the “discounted” value of the gift.

For example, if you invest £500,000 into a DGT and the income stream is valued at £200,000, the taxable gift for IHT purposes is only £300,000. If you survive for seven years after creating the trust, the gifted amount (less your retained income) is entirely outside your estate.

Enhancing the Strategy with Whole-of-Life Insurance

The income you receive from the DGT can be used to fund premiums for a whole-of-life insurance policy, which is designed to pay out a guaranteed sum upon your death. When structured correctly, this approach ensures any remaining IHT liability can be met without depleting your estate.

Step-by-Step Guide to Combining a DGT with Whole-of-Life Insurance

1. Set Up the DGT

  • Transfer a lump sum into the trust and retain a fixed income for life.
  • This reduces your estate’s taxable value immediately, thanks to the actuarial “discount” applied to the gift.

2. Use the Income to Fund Insurance Premiums

  • The regular income from the DGT is used to pay the premiums for a whole-of-life insurance policy.
  • This policy guarantees a payout upon your death.

3. Write the Insurance Policy in Trust

  • By writing the policy in trust, the payout is kept outside your estate and is free from inheritance tax.
  • The trustees or beneficiaries can then use the proceeds to settle any remaining IHT liability.

4. Ensure Beneficiaries Receive the Full Estate

  • Upon your death, the DGT’s remaining assets pass to your beneficiaries, free of IHT.
  • The whole-of-life insurance payout provides a cash lump sum to cover any remaining IHT liability, ensuring your estate is preserved for your loved ones.

Why is This Strategy Effective?

This combination of financial planning tools offers several key benefits:

  • Immediate IHT Reduction: The DGT reduces the taxable value of your estate upon creation, while the seven-year rule can remove the entire gift from your estate for IHT purposes.
  • Guaranteed IHT Cover: The whole-of-life insurance ensures funds are available to pay any remaining IHT bill.
  • Efficient Use of Income: Instead of letting the income from the DGT add back to your estate, it’s redirected to fund an insurance policy.
  • Asset Preservation: Your beneficiaries won’t need to sell family assets, such as property or investments, to pay the IHT liability.

An Example in Practice

Imagine your estate is worth £1,500,000, with an IHT threshold (including the residence nil-rate band) of £500,000. This leaves a taxable estate of £1,000,000 and a potential IHT bill of £400,000 (40% of £1,000,000).

  1. You establish a DGT with £500,000. The actuarial discount reduces the gift’s taxable value to £300,000, immediately lowering your estate’s IHT exposure.
  2. The DGT pays you £20,000 annually as income.
  3. You use this income to fund a whole-of-life insurance policy with a sum assured of £400,000.
  4. Upon your death:
    • The remaining DGT assets pass to your beneficiaries free of IHT.
    • The insurance policy pays £400,000 to the trustees or beneficiaries to cover the estate’s remaining IHT liability.

Things to Consider

  • Affordability: Ensure the DGT’s income is sufficient to cover the insurance premiums, as missed payments can cause the policy to lapse.
  • Flexibility: The income from the DGT is fixed, so inflation may erode its real value over time.
  • Regular Reviews: Work with your financial planner to ensure the strategy remains aligned with changes in IHT laws, your estate value, or personal circumstances.

Final Thoughts

Using a DGT to fund a whole-of-life insurance policy is an innovative and effective way to reduce inheritance tax while ensuring your loved ones are financially secure. By combining these tools, you can create a comprehensive estate plan that preserves your wealth and protects your family’s future.

If you’d like to explore how this strategy could work for you, feel free to contact us today. We’d be happy to guide you through the process and tailor a solution that meets your unique needs.

Please note:

The content of this blog is intended for general information purposes only.

Tax planning is not regulated by the Financial Conduct Authority.