Life insurance and inheritance tax

Your life insurance tax options

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Without careful planning, your family might be charged inheritance tax on your life insurance pay-out

If you have taken out life insurance to provide a lump sum or regular income to your loved ones when you die, there is usually no income or capital gains tax to pay on the proceeds of the policy. However, if the total value of your estate is more than £325,000, inheritance tax (IHT) will be deducted from your insurance pay-out at a rate 40%.

In other words, a pay-out of £100,000 would be worth just £60,000 after IHT. But you can legally sidestep IHT by writing your life policy in trust.

Life insurance and inheritance tax

Inheritance tax is due on the value of your estate above a threshold of £325,000, levied at 40% – unless you leave everything to your spouse or civil partner. In other words, if the value of all your possessions is more than £325,000, tax is due only on anything above that sum.

For example, if you die and your estate is worth £500,000, you would face an IHT bill on anything over £325,000 – which is £175,000. 40% of that is £70,000, which is what you would owe in IHT. Your ‘estate’ includes anything you own including property, cars, money and jewellery – as well as the proceeds of any life insurance.

It also includes your home, but a recent change to IHT rules means that if you leave your home to your children or grandchildren, the threshold increases to £425,000.

The IHT threshold might seem high, but the average house price in the UK is £220,000. Homes are more expensive in the south-east, at an average of £380,000, which is above the standard IHT threshold. It is therefore worth making sure that the pay-out from your life insurance is tax free.

Single life insurance policies are twice as popular as joint

According to MoneySuperMarket data correct as of August 2019

Putting your life insurance policy in trust

A trust is a legal arrangement that allows you to give your policy to trustees, who become the legal owners and look after it on behalf of the beneficiaries.

It’s relatively straightforward to set up a trust. Your insurer should be able to help and the service should be free. You can put your policy in trust at any time, though it makes sense to do it as early as possible, preferably when you first take out the cover.

There are a couple of other advantages to a trust. These include:

  • The arrangement allows you to control who gets the money from your life insurance policy because you specify the beneficiaries
  • It also usually leads to a speedier pay-out. If the policy does not form part of your estate it does not get caught up in the kinds of lengthy legal proceedings that can follow a death, such as probate, so the money should be paid to your beneficiaries much quicker

You might be liable for income tax at the higher and additional rates on a life insurance pay-out if your policy is non-qualifying, which usually means it includes some sort of investment element. The definition of non-qualifying is complex, but your insurer will be able to tell you whether you have a non-qualifying plan.

Tax is a tricky subject, so if you have a non-qualifying policy, or if you are unsure about setting up a trust, you should talk to a specialist adviser.

Types of life insurance policy

There are various types of life insurance, but term insurance is the most common and the most straightforward. Term insurance pays out a cash sum if you die within the term of the plan and is not normally subject to income or capital gains tax. It is known in tax speak as a ‘qualifying policy’.

People take out term insurance primarily to provide financial security for their family. So, if you have young children you might take out level term insurance to pay out a lump sum of £100,000 on death within a 20-year term.

There are various types, each of which works a little differently:

  • Level term insurance: Pays out a fixed lump sum if you die during the policy term. This lump sum won’t change over time, so you and your family know exactly what will be left with in the event that they need to claim
  • Increasing term insurance: Designed to combat rises prices and inflation, the sum insured maintains its real value throughout the term. It is also known as ‘index-linked term life insurance’ and the sum either increases by a fixed amount each year, or rises in line with the retail prices index (RPI) measure of inflation
  • Decreasing term insurance: Covers a debt that gradually reduces over time, such as a repayment mortgage. It is worth considering decreasing term insurance if you have a mortgage or any big debt you would need to pay off in the event of your death. With this type, any pay-out also reduces over time, which means the premiums are understandably lower than for level term insurance or increasing term insurance
  • Convertible term insurance: As its name suggests, convertible term insurance enables policyholders to convert their policy into a whole-of-life policy should they wish to. Good news is that the insurer is obliged to convert the policy regardless of any changes to the policyholder’s health
  • Renewable term insurance: With renewable term insurance, policyholders have the option to renew their life cover when the policy term finishes without the need for a health review

You can also buy something called family income benefit, which makes regular payments to your dependents instead of a lump sum if you die within the policy term.

Single life insurance policies are twice as popular as joint

According to MoneySuperMarket data correct as of August 2019

Compare life insurance quotes

It is wise to compare a wide range of different life insurance quotes to ensure you find the best possible deal. You can compare types of cover to see how premiums change, and you may want to add critical illness cover to your policy.

Remember, however, that you shouldn’t base your decision to buy life insurance on price alone. It’s also important to check the level of cover and to understand whether or not your premiums could rise in future. And as ever, always read the small print.

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