Life insurance and inheritance tax

If your life insurance policy isn't written into trust, your family may be subject to hefty inheritance tax on your life insurance payout.

Life insurance policies can be set up to avoid tax on the payout by writing them “in trust”. This means they won’t be subject to inheritance tax.

If a life insurance policy isn’t written in trust, the payout can go into your estate, which can be taxed at 40%. This is inheritance tax (IHT) and is applied to money which is more than the IHT tax-free allowance.

What are the UK tax rules for inheritance tax?

When someone dies, all of their money and assets are collected together in their estate. This is then divided up between their beneficiaries, either those named in a life insurance policy, a will, or by the rules of intestacy if beneficiaries aren’t named in a policy, or if there is no will.

There is no IHT to pay if the value of the estate is within the allowance of £325,000 for the financial year 2020-2021. This is also the case if anything above this limit is left to a spouse, civil partner, charity or community amateur sports club. Otherwise, anything above this limit is charged at 40% IHT.

If the person who dies has a spouse or civil partner who is still alive, the limit is transferred to this person. This means they now can have a threshold of £650,000 (not including the family home) in their estate before the tax is charged.

Do you have to pay inheritance tax on life insurance?

There may be tax to pay on a life insurance payout. This could happen if the money pushes the deceased person’s estate over the IHT threshold. However, if the insurance policy has been written in trust, which is usually free to do, it will be ring-fenced and will not form part of the estate.

How to avoid inheritance tax

While it’s illegal not to pay tax owed to HMRC, there are legal ways to avoid paying it. One of these is to ring-fence a life insurance payout by writing it in trust. This means the money from the payout is technically not part of your estate, instead it belongs to a trust.

This trust has trustees who can then decide what happens to it, and can manage how it reaches your beneficiaries. As children and minors under the age of 18 can’t be given a life insurance payout, a trust can help as it means an appointed person will be managing the money until the child becomes an adult.

The pros and cons of putting life insurance in a trust

Not everyone will need or benefit from putting life insurance into a trust. It’s generally used as a way to avoid inheritance tax, so whether you need to set up a policy this way will depend upon whether your estate is likely to be subject to IHT.

Pros of putting life insurance in trust

  • You decide where an insurance payout will go, which can especially help couples who are not married or who don’t have a civil partnership.
  • Payouts can be quicker as the money usually doesn’t need to go through probate.

Cons of putting life insurance in trust

  • It can be hard to change a policy if you set it up this way, such as changing beneficiaries or trustees.
  • Some IHT may be applicable if changes are made and the person dies within seven years of this.

Bottom line

One way to avoid paying IHT is to put a life insurance policy in trust. If you think your estate is going to breach the IHT limit, and if your dependents are likely to see a 40% tax bill applied to any payout, this may be a smart financial move to reduce the bill.

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