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Life insurance and tax

Life insurance pays out a lump sum or regular income on death and is one of the best ways to make sure your loved ones can cope financially when you die. 

Beware inheritance tax

The proceeds of a life insurance plan are not usually liable for either income or capital gains tax. But if you’re not careful, inheritance tax (IHT) could take a big chunk out of the policy payout. 


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Inheritance tax is paid at 40% on the value of your estate above the so-called nil rate band of £325,000. In other words, if your estate was worth £500,000, the IHT bill could be 40% of £175,000, or £70,000. 

Big bill

You might not think you need to worry much about the tax. After all, you’re probably not a rich landowner. But IHT can hit families with even moderate wealth. The typical house is now worth about £180,000 or £320,000 in greater London, which isn’t too far from the threshold. 

 
Most life insurance policies are not written ‘in trust’, according to industry figures.

If you add up various other assets such as jewellery, savings and investments, your family could easily end up with a big tax bill. 

Life insurance payout

A life insurance payout can also form part of your estate when you die. For example, if you took out life cover of £500,000, your family could be liable for IHT on the proceeds. And if the taxman takes a bite of the inheritance, there is less for your beneficiaries. 

Avoid IHT

Thankfully, you can legally avoid IHT on any life insurance payout by writing the policy ‘in trust’. It’s a pretty straightforward procedure and should not involve any extra cost. The proceeds of your life insurance are then paid into the trust, which means they do not form part of your estate when you die and so sidestep IHT.

Money in trust

The trust is managed by trustees, usually family members or a solicitor. You can also decide exactly how the money is distributed. You might, for example, want to keep the money in the trust until your children reach a certain age, perhaps 18 or 21, when they are better able to handle their own financial affairs.

Speedy payout

The other advantage to writing a policy in trust is the speed of the payout. If the proceeds do not form part of your estate, your beneficiaries do not have to wait until probate is granted before they can access the cash. In straightforward cases, the insurer should be able to hand over the money with days of the death.

Rightful inheritance

Most life insurance policies are not written ‘in trust’, according to industry figures. Many bereaved families are therefore missing out on their full and rightful inheritance. So always ask about the IHT implications of your life insurance to make sure your loved ones feel the full benefit of any payout. 

Tax planning

In addition to avoiding IHT on a life insurance payout, you can also use a life policy to cover an IHT bill. So, if your family is likely to be liable for IHT on your estate after your death, you can arrange life insurance to pay the bill. 

However, tax is a complex subject so you should talk first to a specialist advisor. 


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