Life Insurance and Inheritance Tax

The information on this page should not be considered as financial advice. If you are unsure what’s right for you, please make sure you speak to a financial adviser. Any references we make to taxation and tax treatment are correct at the time of writing but may be changed in the future.

If you pass away tomorrow, life insurance would provide your loved ones with a financial safety net during a difficult time.

But if your estate is worth more than £325,000 – or up to £650,000 for married couples and civil partners – your beneficiaries could pay 40% inheritance tax.

Learn how inheritance tax can reduce what your family receives from your policy and the things you can do to avoid paying inheritance tax on life insurance, such as placing it in trust.

What is life insurance?

Life insurance pays out a lump sum or regular payments to your chosen beneficiaries if you pass away.

You pay a monthly premium for the benefit of knowing your loved ones will be financially secure when you’re no longer around.

Life insurance payouts are usually free from income tax or capital gains tax. But depending on who they are paid to, it may mean that when added to the rest of the deceased persons assets, that their estate might be subject to Inheritance Tax if it exceeds certain thresholds.

What is inheritance tax?

Inheritance tax (IHT) is applied to the estate of someone who has passed away.

‘Estate’ means everything you own and leave behind for your beneficiaries. This includes your property, savings, investments, treasured possessions and even life insurance payouts.

Inheritance tax was originally designed to apply only to the wealthiest estates. However, due to significant increases in property values over recent years and the fact that tax thresholds have remained frozen, a growing number of people are now being affected by it.

Is life insurance subject to inheritance tax?

In line with Government inheritance tax guidelines, IHT becomes payable if the total value of your estate – including a life insurance payout – exceeds £325,000, known as the nil rate band (NRB).

Not all estates are subject to inheritance tax. If your estate is worth less than £325,000 at the time of your death, no inheritance tax will be due. Any amount above this threshold may be taxed at the current 40% standard rate.

An additional residence nil rate band (RNRB) of up to £175,000 can also apply if you leave your main home to your beneficiaries, such as children or grandchildren, including adopted, foster or stepchildren. This raises your potential tax-free allowance to £500,000 per person.

Married couples and civil partners are exempt from paying inheritance tax when passing assets to each other. Not only that, but unused allowances, like the nil rate band and residence nil rate band, can be transferred to a surviving partner, potentially doubling the tax-free threshold to £1million for couples.

Here are two scenarios that demonstrate how inheritance tax could impact your estate.

Talk to a financial adviser today to get a clear picture of what life insurance and inheritance tax mean for you.

Is life insurance subject to inheritance tax if you place it in trust?

You can legally avoid paying IHT by writing your life insurance in trust, thus separating your policy from your estate. This can ensure your loved ones receive the full payout without being subject to inheritance tax.

The benefits of putting life insurance in trust include:

1. Inheritance tax planning

Because the life insurance policy sits outside your estate, it isn’t subject to probate and can be paid out quickly. This gives your executors the funds they may need to cover any inheritance tax within the six-month deadline.

2. Settle outstanding debts

If you pass away with debts like mortgages, writing your policy in trust ensures your beneficiaries can use the payout to cover what’s owed. This won’t reduce their inheritance or force them to sell the property.

3. Specify who benefits

Putting a life insurance policy in trust allows you to control who benefits from the proceeds. You can name individuals, such as children or grandchildren, or even leave the money to a charity of your choice. In this case, the trustees are legally bound to look after the proceeds and pay them to the beneficiaries you have chosen (depending on the type you use).

4. Faster payout

Policies written in trust allow trustees to access and distribute the money in a matter of weeks. Without one, the payout is included in your estate and must go through probate, which can take several months or longer. 

How do you write a life insurance policy in trust?

To set up a trust for your life insurance policy, you’ll need to appoint ‘trustees.’ These are people you trust to manage the policy and ensure the funds go to your chosen beneficiaries.

This can usually be done at any time, not just when you take out the policy, and may even be free if your estate and policy are relatively simple.

Once the policy is placed in trust, it’s no longer legally yours and this usually means it isn’t counted as part of your estate, ensuring your beneficiaries receive the funds quickly and efficiently. This means your loved ones get the full, tax-free benefit of your life insurance policy.

Are there drawbacks to placing life insurance in trust?

Once life insurance is placed in trust, it usually cannot be changed or altered. This can create complications in situations such as divorce. Any future changes or decisions regarding the policy must also be approved by the trustees.

Before you place a policy in trust, you should weigh up if it’s the best option for you. Speaking to a financial adviser or a solicitor can help you make the right choice for your financial needs and circumstances.

How else can you avoid inheritance tax?

There are various ways to reduce the inheritance tax burden, including donating to charity, contributing to a pension scheme, or making financial gifts of up to £3,000 per year.

Certain tax-free gift allowances, such as those for weddings and annual gifts, can also help lower IHT. These include:

• Up to £5,000 from a parent as a wedding gift.
• £2,500 from a grandparent as a wedding gift.
• Other gifts of up to £3,000 per year to family or loved ones.

Gifts made within seven years of death may still be considered part of the estate for inheritance tax purposes. Similarly, larger gifts given between three and seven years before death are taxed on a sliding scale.

Importantly, inheritance tax must be paid within six months of death. After this point, you may have to pay interest on any unpaid tax. However, IHT can also be paid in instalments over a period of up to 10 years.

Can life insurance pay for inheritance tax?

Yes, life insurance can be an effective way to manage your inheritance tax burden. For example, some life insurance policies can be structured to cover IHT liability. For example, if your estate exceeds the £325,000 nil rate band by £100,000, a life insurance policy valued at £40,000 could cover the resulting IHT.

Similarly, level-term life insurance offers protection for gifts that may fall within the seven-year IHT period, until the gift becomes exempt from IHT.

Do you pay tax on a life insurance payout?

Life insurance payouts are typically tax-free. Your loved ones and beneficiaries won’t pay income tax or capital gains tax on any money they receive from the policy.

However, when policies aren’t written in trust, the payout can be included in your estate and if your estate wasn’t subject to Inheritance tax, the life insurance payout when added could mean your estate is subject to inheritance tax. That means you’ll pay 40% IHT on any money that exceeds the threshold. For example, if the rest of your estate was £325,000 then a life insurance payout of £200,000 once taxed at 40% would leave your beneficiaries with a net amount (after the tax had been paid) of £120,000.

Once your beneficiaries receive a payout, the money becomes part of their own estate. They should check whether this increases the value of their estate beyond the IHT threshold and consider taking steps to reduce potential future tax liabilities.

Do you need advice about life insurance and inheritance tax?

Life insurance forms part of a policyholder’s estate and may be subject to inheritance tax if not properly structured. But the rules around life insurance and inheritance tax can be complex.

From placing your policy in trust to gifting to loved ones, consulting a financial adviser can help you reduce your IHT burden and ensure the payout benefits the people and causes closest to you. Alternatively, request a callback today.