Life Insurance and Inheritance Tax

Although the proceeds from a life insurance policy are typically tax free, you may have to pay inheritance tax (IHT). If liable, your family could lose part of the payout, which could limit the financial support you intended for them.

In this guide, we'll explain how inheritance works and what you can do to legally bypass or minimise tax on life insurance proceeds.

What is inheritance tax?

Inheritance tax is a tax paid on the value of a person’s estate when they die. In the UK, estates valued above £325,000 (the nil-rate band) are taxed at a rate of 40% on the amount above this threshold.

Your estate is the total value of all your assets, including properties, savings, investments, and any other possessions you have at the time of your passing. It can also include a life insurance payout.

In simple terms, only the value of your estate that exceeds the threshold will be taxed. So for example, if the total value of your estate is £350,000, then only £25,000 will be subject to the 40% tax rate.

When is life insurance subject to inheritance tax?

If a life insurance policy is part of your estate, it can push the overall value above the inheritance tax threshold, thereby increasing the taxable amount.

Life insurance is included in your estate for Inheritance Tax purposes if:

• The policy is in your name (i.e. you are the legal owner).

• The payout is made directly to your estate or not placed into trust.

This means your loved ones may receive a reduced amount if your estate exceeds the inheritance tax threshold.

Certain types of policies, such as life assurance, are particularly relevant when it comes to estate planning. As the policy pays out regardless of when you die, it could hold potential implications for inheritance tax if not structured properly.

How to reduce your inheritance tax liability

Fortunately, there are strategic steps you can take to help ensure that your life insurance isn't subject to inheritance tax, allowing your beneficiaries to receive the full benefit of your policy.

1. Put your life insurance in trust

This is one of the most effective ways to bypass IHT on life insurance. Writing your policy 'in trust' means the policy is not part of your estate. The proceeds of the policy will go directly to your chosen beneficiaries, untaxed. It also allows faster access to funds, without going through the probate process.

2. Limit the amount of cover you have

If you know your estate is likely to be close to or exceed the inheritance tax threshold, you could limit the amount of life insurance cover you take out. By doing this, you help ensure that the proceeds will not increase your estate's value, potentially pushing it over the threshold and subjecting it to IHT.

While this may not seem like an ideal option, it might make sense if you have other substantial assets that will be passed down. To learn more about working out your cover needs, see: How much life insurance do I need?

3. Use your annual gift exemption

You can give away up to £3,000 each tax year without it being added to your estate for IHT purposes. If unused, this annual exemption can be carried forward for one year.

Larger gifts may also be exempt if you live for at least seven years after making them. This could be a good option if you want to lower the value of your estate.

4. Make regular gifts out of surplus income

You can make regular payments from your surplus income, such as funding a life insurance policy in trust, without them counting towards your estate. These must be truly regular and not affect your standard of living.

5. Utilise the seven-year rule in Inheritance Tax

If you give away something like a life insurance policy (or the money used to pay for it), and you live for at least seven years after making the gift, it will usually be exempt from Inheritance Tax.

However, if you die within seven years, the gift may still count towards your estate and could be taxed. In this case, taper relief (the closer you get to surviving the full seven years, the less tax your beneficiaries may have to pay) might reduce the amount of tax owed.

Do joint life policies face inheritance tax?

This will often depend on the type of joint life insurance you own and how it's arranged.

There are two main types of joint life cover:

• First death: The policy pays out when the first policyholder dies. The payout usually goes to the surviving policyholder. If you are married or in a civil partnership, the payment is typically exempt from IHT due to the spouse exemption. However, if you are not married or in a civil partnership, the payout may be considered part of your estate and could be subject to IHT.
   

• Second death: The policy pays out only after both policyholders have died. In this case, the payout forms part of the second person’s estate and may be subject to IHT. This is especially relevant if the total value of the estate exceeds the inheritance tax threshold.

To help mitigate inheritance tax, you can choose to place the policy in trust. That way, the payout does not form part of your estate and can be passed directly to beneficiaries, usually without IHT.

Where to get advice on life insurance and IHT?

When buying life insurance, we understand that you want to leave as much as possible to support family and/or loved ones. That's where Cavendish Online can truly make a difference.

Our dedicated advisory team is committed to offering professional advice on a wide range of protection products, from life insurance to income protection and critical illness insurance.

We understand that everyone's needs are unique, and we're here to help you make informed decisions with confidence. We can discuss how you can manage your policy to bypass any inheritance tax implications, such as placing your policy into trust or selecting the right type of life insurance for your needs. Speak to an adviser to get started.