BENNETTS - Inheritance Tax: Discounted Gift Scheme

Discounted Gift Scheme

You make a gift of a single premium life policy on your life in return for a fixed income from the policy, typically 5%. The result is that the value for Inheritance Tax purposes of the gift is immediately discounted. Thus one might buy and gift a policy worth £100,000 but the gift would only be valued at £70,000 for Inheritance Tax purposes, saving (at 40% tax if you die within three years) £12,000 in tax.

Advantages

The gift reduces one's chargeable estate immediately, instead of having to wait for three years to any tapering in the level of Inheritance Tax imposed, and a full seven years for the "slate to be wiped clean".
Taking 5% from an insurance bond for up to the first twenty years is treated as a return of capital and there is no tax charged on this "income".
If the 5% figure is exceeded, a standard rate tax payer still has no tax to pay on the money received.
Gifting a policy means that any subsequent growth in the value of the policy fund takes place outside your estate.

Disadvantages

A donor paying higher rate tax would have to pay tax on the difference between the standard and higher rates on withdrawals of over 5% per annum. If you simply gave money directly to a family beneficiary who was not a higher rate tax payer, the total tax bill for the family unit (including you and the beneficiary) would be less
Life companies' average rate of return on an investment policy is no better, before charges, than can be achieved by direct investment in the stock market,
The gift is "wrapped" in an insurance product on which there are initial (typically 5%) and annual (1%) charges, which is why such schemes tend to be promoted by advisers who earn commission.
The scheme will not work where you are in poor health, because little or no discount will be allowed in such cases by the tax authorities.
For many people trying to reduce their estate, a return of 5% of the gift each year will only add to an estate they are trying to reduce. Thus, after seven years, the reduction in estate will have been partially off-set by repayments of 35% of the initial gift. If you survive 20 years, the whole value of the initial gift will have been returned to you.
A lifetime gift Inheritance Tax charge of 20% will be payable on the extent to which the gift, along with any other such gifts, or gifts to a discretionary trust, within a seven year period exceed the Nil Rate band. Outright gifts, by contrast, are without limit "potentially exempt transfers" and not taxable if the donor survives seven years.