How can I protect my life insurance payout from inheritance tax?

Key takeaways

• Life insurance provides a financial safety net for loved ones if you pass away

• If your estate is worth more than £325,000 (or £650,000 for married couples/civil partners), your beneficiaries could pay 40% inheritance tax

• To avoid paying IHT write your life insurance into a trust to separate it from your estate

What is life insurance?

Life insurance is a financial safety net and a form of protection insurance. You pay a monthly premium, and in return, if you were to pass away suddenly, the insurer would pay out a lump sum or regular payment to your beneficiaries.

This payout is typically free from income tax or capital gains tax, and is a direct benefit to your loved ones such as children or grandchildren.

What is inheritance tax?

Inheritance tax (IHT) is a levy on the estate of someone who has passed away. It's designed to tax the wealthier estates, but with property prices on the rise, more individuals find themselves within its reach.

If your estate is valued at £500,000, for example, it would be £175,000 above the IHT threshold, resulting in a £70,000 HMRC tax bill for your heirs.

Is life insurance exempt from inheritance tax in the UK?

Life insurance payouts are not directly taxed, but they can be subject to inheritance tax unless the policy is written in trust, keeping them outside of the estate for inheritance tax purposes.

If the payout is not in a trust, it becomes part of the deceased's estate and could be subject to inheritance tax if the estate exceeds the £325,000 threshold.

Why is inheritance tax added to life insurance?

Your beneficiaries could be hit with a 40% inheritance tax (IHT) bill if your estate—comprising everything you own, from property to jewellery, investments to cash—totals more than £325,000, or £650,000 for married couples or civil partners.

For instance, a £100,000 life insurance payout could be reduced to £60,000 after IHT, a substantial loss and tax liability for your family.

Your beneficiaries will be expected to pay IHT if your life insurance payment forms part of your estate.

How can you avoid paying inheritance tax on your life insurance?

There is a way to legally avoid paying IHT by writing your life insurance in trust. This is a legal qualifying arrangement that separates the policy from your estate, ensuring the full payout goes to your beneficiaries without being subject to IHT.

How can you write a life insurance policy in trust?

To place a policy into trust, you'll need to appoint trustees to manage the policy for the benefit of the dependents you would like the money to go to.

This can be done at any point, not just when you buy the policy. It may also be free of charge, if your estate and life insurance policy are relatively straight forward.

When the policy is placed in trust, this ensures that the payout is not considered part of your estate for inheritance tax purposes and that your beneficiaries receive the money promptly.

How else can you avoid inheritance tax?

There are several strategies to reduce the inheritance tax burden, such as donating money to charity, contributing to a pension, and making financial gifts up to £3,000 per year.

Specific tax-free gift allowances related to weddings and annual gifts can also help in reducing the IHT. These include:

• Up to £5,000 from a parent as a wedding gift

• £2,500 for a grandchild or great-grandchild as a wedding gift

• Other gifts of up to £3,000 in total to loved ones in any given year

If you make a gift within seven years of your death, it may be included in your estate for inheritance tax purposes.

There is a sliding scale of taxation for larger gifts given between three and seven years before the giver's death, with gifts given more than seven years before death not being liable for IHT.

It's important to note that IHT must be paid within six months of the person's death, and there can be interest charges on unpaid IHT, which can be paid in instalments over 10 years.

Can life insurance be used to pay an inheritance tax bill?

Life insurance payouts can be a versatile tool in managing IHT. Whole of life policies for instance, can be designed to cover the IHT bill. If your estate is £100,000 over the threshold, a policy worth £40,000 could cover the IHT due.

If you're concerned about a gift falling within the seven-year IHT window, a level-term policy could provide coverage until the gift is exempt from IHT calculations.

What is the inheritance tax on property?

When it comes to property, inheritance tax is typically 40% on values above the £325,000 threshold. However, if you leave your main residence to a child or grandchild, the threshold can effectively increase to £500,000, though this additional allowance decreases for estates worth over £2 million.

Potential stumbling blocks related to the residence nil-rate band include:

• The reduction of the additional £175,000 residence nil-rate band by £1 for every £2 above £2 million the estate is worth.

• The disqualification from the £175,000 tax-free allowance if the property is written into trust.

We always recommend you speak to a financial adviser if you're unsure about anything relating to life insurance and tax.

How can I find the best life insurance for me?

With the complexities surrounding life insurance payouts and inheritance tax, it's wise to shop around and compare life insurance quotes to find the best cover for your needs. Remember, the right policy isn't just about the premium; it's about ensuring your loved ones are protected from financial strain if you were to die.