What is the effect of inheritance tax on life insurance?

If you have to pay IHT on a life insurance pay out when you die, it could significantly reduce the money your loved ones receive.

Find out how the pay out could be taxed and the steps you can take to ensure all of the money goes to your family.

What is inheritance tax?

Inheritance tax (IHT), sometimes called the 'death tax,' is a government levy on assets a person leaves behind when they pass away.

The tax allows the government to claim a portion of the deceased's estate, including money and property, before transferring it to their heirs.

This can be a real source of stress to those that want to pass family wealth on to the next generation.

IHT is typically charged at a rate of 40%, but there are allowances and exemptions that you may be able to take advantage of.

So, individuals should carefully plan their estate to minimise its impact.

How does life insurance work?

Life insurance provides a financial safety net for your loved ones, if you die.

In return for the payment of regular premiums, the insurance company will pay a cash lump sum to your chosen beneficiaries when you die.

They can spend this money as they wish, but it’s typically used to pay for the following:

• Pay off your mortgage and other debts

• Cover funeral expenses

• Provide ongoing financial support for your dependents

Most people choose term insurance. This means that you are insured for a specific term such as 20 or 30 years.

But you can also buy whole-of-life insurance. This is more expensive but will pay out whenever you die. 

Life insurance pay outs will form part of your estate when you die - and potentially be subject to IHT.

But, it’s possible to get around this by arranging for the policy to be written in trust.

Do you pay inheritance tax on life insurance?

Whether you pay inheritance tax on a life insurance payout depends on how the policy is set up. If the policy is written in trust, life insurance payouts are usually exempt from IHT.

This means the proceeds do not form part of the deceased's estate and are directed to specific beneficiaries of the trust. 

However, if the policy is not written in trust and the total value of the estate - including the insurance payout - is over the tax-free threshold, it would be subject to tax at 40%.

So, it's essential to structure your policy carefully to minimise or avoid IHT on life insurance.

This is usually a simple matter of completing paperwork from your insurance company.

However, care and professional advice should be taken if the policyholder wants to put the policy in trust and they are suffering from a serious or terminal illness, as this can have IHT implications.

If someone is seriously ill and may pass away soon, the policy's value may increase, so putting this in trust could be a taxable gift. 

Whole-of-life insurance policies may be treated as a taxable gift for IHT if you put them in trust as they definitely pay out, so it’s worth taking advice.

Is a life insurance premium tax-deductible?

In the UK, most insurance policies, such as life insurance and critical illness cover, are generally excluded from the  income tax regime.

Policy premiums are not tax-deductible, and policy payouts are usually tax-free. This means that the funds received due to a claim are not subject to income tax.

However, it's essential to consider the specifics of each policy as some types of insurance, such as investment-linked policies, have tax implications. 

An adviser should be able to explain if this is relevant to you.

Is avoiding inheritance tax possible?

Careful estate planning can reduce inheritance tax.

Here are some of the legal ways to reduce a potential IHT bill:

Annual gift exemption

One way to avoid inheritance tax is to use your annual gift exemption. Each year, an individual may gift up to £3,000 without incurring IHT.

This money can be given to one person or split between several. Any allowance that you didn’t use last year, can be carried forward to the next year.

Regular gifts out of surplus income

You can give away as much as you like from your surplus income and it will be immediately free of IHT.

This can provide a helpful way to help the next generation - for example paying for school fees, university accommodation bills, or music lessons and tuition for younger grandchildren.

The seven-year IHT rule

If your gifts aren’t covered by any allowances, you’ll need to live for a further seven years, for them to fall outside your estate and be free of IHT.

If you die within seven years of making a gift, it may be included in your taxable estate.

However, if the gift is over the nil rate band, then taper relief may be available to reduce the tax bill on the excess.

It's recommended to stay up-to-date with changes in tax regulations, especially regarding thresholds.

This is where consulting a tax professional or financial adviser for personalised advice based on current tax rules and your circumstances can be invaluable.

Using whole of life insurance to avoid IHT

Some people also take out whole-of-life insurance policies to legally avoid paying IHT. 

So long as the policy is written in trust, the beneficiaries can use the pay out to pay the policyholder’s IHT bill.

Can you put life insurance in a trust?

Putting life insurance in a trust is straightforward, and doing so offers several benefits.

Placing a life insurance policy into a trust is called 'writing the policy in trust.'

Below are some advantages to consider.

Legally avoiding inheritance tax

A primary advantage of writing a life insurance policy in trust is that the proceeds are typically exempt from IHT.

This means the payout goes directly to the beneficiaries and is not considered a part of the deceased's estate, avoiding inheritance tax.

Faster payouts

Putting a life insurance policy in trust can expedite the payout process. Since the funds aren't subject to probate, you can provide swift financial support to dependents.

Control and flexibility

When a life insurance policy is written in trust, the policyholder can specify the disbursement of proceeds. This provides greater control for complex family situations.

Privacy

Trusts offer privacy as they are separate legal entities, so the payout amount and beneficiaries are not included in public records.

Estate planning

Writing life insurance in trust is a common estate planning strategy.

It helps people ensure their assets are distributed according to their wishes while minimising the impact of IHT on their estate.

Seek expert financial and insurance advice

Life insurance is part of a policyholder's estate and is subject to inheritance tax if not carefully planned. 

You can avoid inheritance tax and streamline the payout process by including life insurance in trust.

Another option to minimise your tax bill on death is to give money annually as a gift within the threshold or to give regular gifts out of your surplus income.

Given the complexity surrounding tax laws and writing policies in trust, talking to a financial adviser or insurance broker via Unbiased for expert financial advice is worth considering.