Taking out life insurance cover will give you peace of mind that your loved ones will be financially supported should the unexpected happen or when you pass, but without mindful planning, your loved ones could be required to pay inheritance tax (IHT) on your life insurance pay-out.

Although the life insurance pay-out itself does not incur a specific tax, if it is considered as part of your estate it will contribute to the amount payable in inheritance tax. Luckily, there are ways to legally get around IHT, and this guide will take you through the best ways to do this.

Life Insurance and Inheritance Tax

How much is inheritance tax in the UK?

Inheritance tax of 40% must be paid on the value of an estate above a threshold of £325,000 unless the entire estate is left to a spouse or civil partner. For instance, if your entire estate is worth £600,000 when you die, your beneficiaries will have to pay inheritance tax of 40% on £275,000, i.e. anything above the threshold of £325,000.

What assets count in a person’s estate?

A person’s estate includes money, property, cars, jewellery, investments, and other assets like businesses, as well as a life insurance pay-out.

If you leave your home to your children or grandchildren, the inheritance tax threshold increases to £425,000, and, according to GOV.UK there is a reduced rate of 36% IHT if you leave more than 10% of your estate to charity.

When DO you have to pay tax on life insurance pay-outs?

It is possible to have a life insurance pay-out that doesn’t incur any IHT but there are instances in which life insurance pay-outs will definitely be taxed and will have to be paid by the beneficiary/beneficiaries.

The instances when you have to pay tax on a life insurance pay-out are:
• If interest has built upon the lump sum of the life insurance policy between the time the policyholder died and when it was transferred to the beneficiary/beneficiaries.
• If the life insurance policy is ‘non-qualifying’ as the result of including an investment.
• If the beneficiary is not an individual/s but rather an ‘estate’ with a value over the threshold of IHT.

If your life insurance policy has built up interest, it will be the beneficiary/beneficiaries who are responsible for including this within their tax return. Therefore, the tax they will be required to pay will depend on their individual income.

How to Avoid Paying Tax on Life Insurance Pay-Outs

There are a number of ways in which you can ensure that your beneficiary/beneficiaries will not have to pay tax on your life insurance pay-out. These are:
• Leave your entire estate to your spouse or civil partner
• Put your life insurance policy into a trust
• Set aside some money specifically to pay IHT.

Leaving Your Estate to Your Spouse or Civil Partner

If you are survived by your spouse or civil partner when you die, your unused life insurance benefit is automatically passed on to them. When they pass away, their estate will incur inheritance tax, but their IHT threshold may be as much as £650,000 so it is much less likely that any tax will actually need to be paid.

Put Your Life Insurance Policy into a Trust

Another way to avoid inheritance tax is to put your life insurance policy into a trust. In legal terms, a trust is an agreement that gives you the ability to hand your life insurance policy over to trustees chosen by you. These trustees, typically family members, friends, or your solicitor, then become legal owners of your policy. In other words, they look after your life insurance policy for the sake of your beneficiaries.

By putting your life insurance policy into a trust, you are separating it out from the rest of your estate, so it is not included in the total and will not incur any inheritance tax.
It is relatively simple to put your life insurance policy into a trust, and it shouldn’t cost you anything to do so. Your life insurance provider should be able to help you to put your policy into a trust, and it is best to do this when you first take out the cover, although it can be done at any time.

Besides being able to avoid IHT, there are other advantages to putting your life insurance policy into a trust:
• A trust gives you total control over who your life insurance payout goes to, rather than being lumped in with your estate. The life insurance payout can be transferred to whomever you specify.
• Payouts can be much faster. Since your life insurance policy is not considered as part of your estate when it is in a trust, it won’t have to go through the legal proceedings, such as probate, that can often take a lot of time.

Bear in mind that once the life insurance policy has been put into a trust it cannot be adapted. Therefore, you should weigh out your options carefully before deciding to do this with your policy.

Set Aside Money Specifically for IHT

Although this doesn’t mean that IHT is truly avoided for your beneficiaries, it does mean that the inheritance tax payments will effectively be paid by you, rather than taking money from the amount promised to your beneficiaries, which is certainly much less stressful for them, and means they can move on with their lives easily and get the full benefits of your life insurance pay-out.

How to Reduce IHT Through Life Insurance

There are a number of different life insurance policies to choose from, but you could actually reduce the amount of IHT that would need to be paid by taking out a Whole of Life insurance policy.

A Whole of Life insurance policy is often used to mitigate inheritance tax so that any payout sum should cover the total amount of IHT payable.

Do you have to pay tax on a workplace life insurance policy?

You may have a life insurance policy taken out by your employer at your workplace, sometimes known as ‘death in service’ benefits or ‘group life insurance’. As this type of life insurance is not classed as ‘benefit in kind’, you shouldn’t have to pay any tax on this cover.

It is also typically written into a trust so it will not be included as part of your estate, and therefore your beneficiary/beneficiaries wouldn’t have to pay IHT anyway.

What Should I Do If I’m Not Sure What I Need to Do Next?

If you’re not sure how to choose the right life insurance policy for you, or if you’re not sure what the best steps you can take to protect your family from a tax burden, then please don’t hesitate to reach out to us. We are more than happy to talk you through your options, discuss different life insurance policies, and help you decide on your next best steps.

Contact us today on 0161 537 0555 to talk to one of our friendly team members and get all the information you need to take the best next step for you and your family. Once you’ve made the right decisions, you can move on and get on with living, knowing your loved ones are well taken care of after your passing.