Ask Annie: Will a life-policy payout clear the bill for inheritance tax?

Q: Many years ago, my mother took out life insurance designed to offset the effects of inheritance tax (IHT). The proceeds from this policy can be used to pay any IHT due on her estate. But after years of rising house prices, she wonders whether the policy will produce enough money to offset what may be a higher tax liability.

How can my mother calculate if she is fully covered?

EK, Taunton

A: A whole-of-life policy pays out on the death of the person insured. It doesn't stop an inheritance tax bill being triggered, but the idea is that this sum will equal the amount due for IHT, so leaving the deceased's estate intact.

Unfortunately, you don't supply an estimate of the value of your mother's estate or the size of the policy payout, so it is impos- sible to give you a definitive answer. But I can give some pointers to help you do the calculations.

There are a couple of factors that can make whole-of-life policies less than ideal. As you point out, house prices have been rising and the estate may end up being worth more than was originally estimated. In addition, the policy may not have performed as well as had been expected at the time it was bought. In both instances – increasing property prices and investment underperformance – there could be a shortfall.

You also have to consider any changes in what is called the "nil-rate band". This is the total value of assets that a person is allowed to leave – other than to a spouse or designated charity – without it triggering an IHT charge. Everything above the nil rate may be subject to the tax.

Just to confuse matters further, the band changes each year. Normally it goes up at the same rate as inflation, but in the past few years – thanks in part to a concerted campaign in the media – it has risen by more than inflation. All in all, working out a future IHT liability is a very imprecise science.

All you can do is a quick estimate from where you are today. Work out what your mother's assets are worth and set that against the current nil rate. For your reference, the band for the 2007-08 tax year is £300,000.

There is one figure you can rely on: your insurance will contain a sum assured – the amount of money it is guaranteed to pay out. Investment underperformance may affect the premiums you are asked to fork out, says Peter Timberlake at insurer Standard Life, but not the sum you get back.

"Whole-of-life policies will typically have a review stage built into them – usually every 10 years – when the insurer will assess whether it needs to raise premiums to keep you on target for this figure," he says. "It is then up to the insured person to agree to pay higher premiums or accept a lower guaranteed figure."