Guides

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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 to tax are based on our understanding of current legislation at the time of writing, which can change in the future.

Life insurance provides a financial safety net for your loved ones, should you no longer be around to provide. It provides a payout if you were to pass away or be diagnosed with a terminal illness during the policy term. 

However, the payout from a life insurance policy can be impacted by inheritance tax (IHT) if not held in a suitable trust. In the below guide we explore life insurance and inheritance tax, helping you to maximise your financial legacy.

What is inheritance tax?

Inheritance tax (IHT) is a tax on the value of your estate after you pass away. Your estate includes everything you own - such as property, savings, investments, personal belongings and life insurance.

In the UK, there’s currently a tax-free threshold of £325,000, known as the nil-rate band. 
Therefore, if your entire estate is valued less than this figure, your beneficiaries won’t have to part with a penny in tax. You do though have to report it to HMRC regardless.

However, if your estate is worth more than this, the amount above the threshold will be taxed at 40%. This threshold can rise to £500,000 if your estate includes a home passed on to direct descendants (such as children or grandchildren).

Inheritance tax example

If your estate is worth £400,000, it would only be taxed on the £75,000 that exceeds the threshold so your inheritance tax bill would be £30,000 in total.

This tax generally has to be paid before the remainder of your estate is passed on to your beneficiaries and so the payment is generally arranged by the executor if there is a Will, If you make a will you can choose who your beneficiaries are and although you might choose are family members, they can be whoever you wish, including friends or even a charity. BUT, if you don’t make a will, your estate will be distributed according to the laws of Intestacy, and so you don’t then get a choice over who would inherit.

It’s important to note that tax rules can change, and the exact liability depends on your personal circumstances. Planning ahead with life insurance and inheritance strategies can help reduce the impact on your beneficiaries and ensure more of your wealth goes to your loved ones. 

Do you have to pay inheritance tax on life insurance?

The proceeds from a life insurance payout, (unless the policy is written in trust), will form part of your estate after you’ve passed. If the value of your estate exceeds the £325,000 threshold (including the value of your life insurance), the excess would be subject to 40% inheritance tax.

For married couples and those in a registered civil partnership, the surviving spouse may be able to combine their £325,000 thresholds. This would mean that there's no inheritance tax to pay on estates worth up to £650,000.

In summary, yes, a life insurance payout does form part of your legal estate and therefore may be subject to inheritance tax, depending on whether the valuation exceeds the current threshold. However, there is an easy way to detach your life insurance from your estate – writing your policy in trust.

Does writing your life insurance in trust avoid inheritance tax?

Putting your life insurance in trust is an easy way to ensure the proceeds from your policy don’t normally form part of your estate; and therefore, aren't subject to IHT. At LV= we've created an online trust tool for your convenience.

A trust is simply a legal arrangement which allows you (the settlor) to specify who you wish to benefit from your policy (the beneficiaries), after you're gone.

It enables you to choose someone or a group of people you trust (the trustees) to manage the payout on behalf of your beneficiaries, much like the executor of a Will.

When you pass away, it’s the responsibility of the trustees to make a claim and ensure your beneficiaries receive the funds as you have instructed - whether that be upon your passing or at a specified time in the future - for example after your children reach adulthood.

It’s important to understand that whilst there could be significant financial advantages from putting your life insurance in trust, you’re essentially handing over ownership of your policy to a 3rd party, which means it’s no longer considered part of your estate. Therefore, assigning a trustee/s requires careful consideration. 

Lastly, some trusts can be difficult to amend if your personal circumstances change, for example you get remarried or have more children and therefore may not to suitable. 

Please see our dedicated LV= life insurance in trust guide for more information on the key advantages and disadvantages.

If you are considering trusts it’s a good idea to speak to a solicitor or a financial adviser, to discuss your specific requirements.

Is it possible not to pay inheritance tax?

As stated above, if your estate is worth less than the threshold of £325,000, you won’t be liable for inheritance tax. But there are a number of ways to minimise the amount of tax you'll have to pay if your estate is valued above.

The first is to leave everything above the threshold to a spouse or registered civil partner (or a charity or community amateur sports club). In this instance, there’s generally no need to pay any inheritance tax, with your estate just passed on. However, this isn’t always possible, especially if you yourself are a widow or widower, or you are simply co-habiting with your partner, and haven’t got married to them, or entered a registered civil partnership.

If you're in this situation, but have children or grandchildren, you're able to give away your home to them, but it will still count towards your estate’s value and therefore could be taxed. The benefit of doing this is that your threshold increases to £500,000, but there will still be tax to pay on anything over this amount.

It's possible to pass on your entire estate to others through gifting without having to pay any IHT, but this requires some forward planning and there are a number of rules to remember.

Can you use life insurance to pay inheritance tax?

Yes, it’s possible to use a life insurance policy to pay inheritance tax. Typically, a whole of life insurance would be the most suitable policy type, as a payout is assured when and not if you pass away (assuming to keep up with your premium payments).

Please note, LV= don’t currently sell whole of life insurance policies.

The pros and cons of gifting

The big plus of gifting is that it is technically possible to give away your entire estate (even if it’s worth more than the £325,000 threshold) without paying a penny of inheritance tax. However, there are certain barriers to ensure it’s not as simple as that.

The first thing to consider is that there is a seven year rule with gifting. Essentially, anything you’ve gifted in the seven years prior to your death will contribute to your estate’s value. But anything gifted before these seven years is exempt.

For example, if you gift £500,000 of your estate and manage to live another eight years, there will be no tax to pay the £500,000 gift. But if you were to pass away within those seven years, a sliding amount of tax would be owed on any gifts that took the estate’s value passed the £325,000 threshold. In this instance, the person who received the gift are the ones who would have to pay the owed inheritance tax – which can range from 8 to 40 per cent depending on the number of years that had passed since the gift occurred.

Ultimately, there is a big risk in trying to gift your way out of paying inheritance tax on large amounts of your estate. But there are a number of smaller and less hazardous way of supporting your children and grandchildren financially through gift exemptions.