Life insurance and inheritance tax

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You’ve taken out a life insurance policy to provide financial support to your loved ones in case of your premature demise. Congratulations.

The good news is that the proceeds, in the unfortunate event that your beneficiaries need to make a claim on the policy, are not usually subject to either income tax or capital gains tax.

The bad news, sadly, is that inheritance tax (IHT) could be due if the pay out from the policy ends up counting towards your estate.

Here’s a closer look at the relationship between life cover and IHT, plus tips on how to avoid paying IHT on the proceeds of a life insurance policy.

What is IHT?

IHT is a tax applied to the ‘estate’ of a person who has died. In this context, an estate can include property (such as the family home), other possessions (such as cars) and money. The latter potentially includes the proceeds from a life insurance policy pay-out.

The tax isn’t usually levied if the value of an estate falls below the so-called ‘nil rate band’ which currently stands at £325,000. Nor does it apply where all of an estate’s proceeds have been left either to a spouse or civil partner, or a third party with exempt beneficiary status (such as a charity).

However, if your estate is worth more than £325,000 and the above scenarios don’t apply, then the part of your estate above the threshold could be liable for IHT at an eye-watering rate of 40%.

IHT and married couples

Married couples and those in a civil partnership can share their thresholds and transfer the unused element of their IHT-free threshold to their partner when they die. This means that a married couple or registered partnership can pass on £650,000 before IHT becomes payable.

In addition, if you are leaving a property to a direct descendant, for example a child or a grandchild, you can benefit from an additional tax-free allowance per person of £175,000. This has the effect of increasing a couple’s combined threshold to £1 million.

Do I pay IHT on life insurance?

The proceeds from a life insurance policy will form part of your legal estate unless you take action to prevent this happening. If a life insurance pay-out means that the value of your estate exceeds the £325,000 IHT threshold, the part of your estate above this will be liable to tax at 40%.

That potentially means a significant reduction in the pot of money that was originally intended to financially support your loved ones and dependents in the event of your passing away. Fortunately, however, some smart financial planning can rectify this scenario.

Draw up life insurance ‘in trust’

The simplest way to avoid IHT being charged on life insurance is to have the policy written ‘in trust’. This keeps any pay-out from being included in your estate.

A trust is a legal arrangement which appoints trustees, such as a solicitor, family members and friends, to oversee the policy on behalf of beneficiaries until the moment comes when they are set to benefit.

Writing a policy in trust should ensure that the pay out reaches loved ones quickly as it side-steps probate - the legal process and paperwork associated with sorting out a dead person’s estate.

Setting up a trust should be straightforward and your life insurance provider ought to be able to help with the process. It usually requires nothing more than a signature on your part.

Many insurers will routinely ask if you want to have your policy written ‘in trust’ during the purchase process.

Generally speaking, it makes sense to set up a trust when the life cover is first taken out. But it’s possible to put a policy into trust at any time. Again, the life insurance company should be able to facilitate this with the minimum of fuss.

Can I use life cover to pay IHT?

When you die, any IHT owed needs to be paid before loved ones are granted access to your estate. This means they could be forced to foot a bill of thousands of pounds in one go.

If you know that your beneficiaries are going to be liable for IHT in the event of your passing, you could take out a ‘whole-of-life’ insurance policy to offset the full amount of the IHT bill.

Whole-of-life cover pays out whenever you die, in contrast to term life insurance. which only pays out if you die during a specified period.

To avoid the proceeds incurring IHT, a whole-of-life policy would again need to be written in trust. The premium paid for the policy will also help to reduce the value of your estate which, in turn, can further reduce the amount of IHT due when you die.

IHT planning can be a complicated business. An independent financial adviser can help with tax and estate planning to ensure that your wishes are carried out and to maximise the proceeds your beneficiaries eventually receive.