Life insurance and inheritance tax

What is inheritance tax?

Inheritance tax (IHT) is a levy charged on the estate of someone who has died.

An estate is effectively what you leave for your beneficiaries to inherit. It includes your savings, investments, assets and material possessions, including your home, cars, jewellery and money, minus any debts.

Inheritance tax may be payable if all this adds up to more than £325,000.

Do you pay inheritance tax on life insurance?

Your life insurance payout might be counted as part of your estate. If that’s the case, it could be liable for tax if the total value of your estate is more than £325,000. Whoever is handling your affairs will have to pay 40% inheritance tax on anything above that threshold, using funds from your estate.

But there are a couple of important exceptions to understand when working out whether your life insurance policy payout is subject to inheritance tax:

• If you leave your home to your children or grandchildren (and your home is worth less than £2 million), you could benefit from an inheritance tax-free threshold of up to £500,000. The extra £175,000 is known as the ‘residence nil rate band’ (RNRB).

• You won’t have to pay any IHT on anything you leave to your spouse or civil partner, even if it’s above the tax-free threshold. You can also pass on any part of your inheritance tax-free allowance to your surviving partner. That means your partner could then potentially pass on up to £650,000 free from inheritance tax, or £1 million if they can also take advantage of the full RNRB.

Examples of life insurance and inheritance tax

These examples illustrate how inheritance tax could affect your estate:

• The total value of your estate comes to £500,000, including £100,000 of life insurance. This means it exceeds the £325,000 IHT threshold by £175,000. This excess is taxed at 40% (£70,000). Therefore, your beneficiaries will be left with £430,000.

• The total value of your estate comes to £500,000, but £280,000 of this is your home. You pass on your property to your children, leaving other assets including life insurance worth £220,000. This is below the inheritance tax threshold, so no tax is due.

Should I put life insurance in trust?

Putting life insurance in trust can protect it from inheritance tax, as it won’t be considered as part of your estate. That way, your beneficiaries can benefit from the full payout.

A trust is a legal agreement that enables you to hand over the management of your policy to the people you name as trustees, who take on the role of legal owners. They take care of your policy for the sake of whoever you name as the beneficiaries. Trustees can be family members, friends or your solicitor.

Your insurance provider should be able to help you with the process of putting life insurance in a trust. It’s best to do this when you first take out life cover.

Benefits to putting your money in a trust include:

• The money from your policy is paid directly to your family or other beneficiaries.

• Often, there’s a faster payout as your policy won’t get caught up in probate (the process of proving the last will made by the deceased).

Downsides of putting life insurance in a trust

• After a policy has been put in a trust, it typically can’t be changed in the future. This could cause complications if you get divorced, for example.

• Any future decisions about the policy will need approval from the trustees.

You should think carefully about whether putting your policy in a trust is your best option. You may want to seek independent financial advice before making a decision.

For more information, read our guide to writing life insurance in trust.

What if I die and leave a surviving spouse or civil partner?

When you die, you can pass on your assets to your spouse or civil partner free from inheritance tax, along with any of your unused inheritance tax allowances.

If you don’t use any of your own allowances, it means your partner’s estate will only be taxed after they die if it’s valued at more than £650,000, or potentially more than £1 million when leaving their home to their children or grandchildren.

What if I die and I am co-habiting?

If you and your partner are living together without being married, you won’t have the same exemption from paying inheritance tax as married couples and civil partners. But even if you’re unmarried, you can name your partner (or anyone else) as the beneficiary of your life insurance.

Because you’re not exempt from inheritance tax, writing your life insurance in trust could be particularly helpful if you’re part of an unmarried couple. If the life policy isn’t written in trust, any payout will be added to your estate and your other half could face paying inheritance tax on anything over £325,000.

This is also the case if you have a joint life insurance policy and you’re unmarried. The payout will go to your partner when you die, but will be considered part of your estate for inheritance tax purposes.

For more details, read our guide to joint life insurance.

Can I use life insurance to cover inheritance tax?

Setting up a whole of life insurance policy in trust can help pay an inheritance tax bill. Once you’ve bought the policy it should be free to put it in trust, although there may be fees involved if you seek legal or financial advice

Your family can use the payout to pay any tax owing without having to raid your savings or sell your property or possessions.

A whole of life policy guarantees that it will pay out a lump sum whenever you die (so long as you keep paying the premiums). This is unlike a term insurance policy that only pays out if you die during the fixed period of the policy.

Do you pay tax on a life insurance payout?

The life insurance payout itself isn’t subject to tax, so your beneficiaries won’t pay income or capital gains tax on it. However, the value of your policy will form part of your estate unless it’s written in trust and will go towards your inheritance tax threshold.

Planning ahead is important to protect your family. The money will become part of their estate after they receive a payout. This means that they, too, may want to take action to minimise inheritance tax if it pushes them over the threshold.

What else do I need to know about life insurance and tax?

There are some other situations where tax could be payable on life insurance, for example:

• If any interest has been earned on the lump sum during the period between the death of the policyholder and the transfer to the beneficiaries.

• If your policy includes some element of investment. This is known as a ‘non-qualifying’ policy. It’s best to speak to an expert about your options if this applies to you.

Life insurance and inheritance tax: planning tips

Rising house prices mean more grieving families than ever before are being hit by inheritance tax.

If you’d prefer more of your hard-earned cash to go to your loved ones rather than the taxman:

• Tot up the value of your property, possessions, savings and investments, minus any debts. You can stop worrying if it’s under the inheritance tax thresholds, which can stretch as far as £1 million for a married couple leaving their home to their children or grandchildren.

• Consider writing any life insurance into trust, so any payout escapes inheritance tax and avoids delays due to probate.

• Fill in ‘expression of wish’ or ‘nomination of beneficiaries’ paperwork if you have life insurance or death in service benefits at work, saying who you’d like to receive any payout.

• Write a will, especially if you’re part of a couple but not married.

• Give stuff away while you’re alive, if you can afford it, to avoid the tax man taking 40% after you die.

• Plan ahead. Some gifts only escape inheritance tax if you live for more than seven years afterwards.