Life Insurance and Inheritance Tax: Rules Explained

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Resources > Life Insurance and Inheritance Tax: Rules Explained

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Inheritance Tax (IHT) can be a complex part of estate planning, especially when considering how it impacts your life insurance policy. Many individuals in the UK want to understand how life insurance payouts are treated for IHT purposes and what steps they can take to protect their beneficiaries from unexpected tax bills.

This guide explains the rules around Inheritance Tax and life insurance to help make sure your loved ones receive the full benefit of your policy.

This article covers:

• What Inheritance Tax is and how it works in the UK.
• Current Inheritance Tax rates and tax-free thresholds.
• Important exemptions and allowances that can reduce your IHT liability.
• How life insurance payouts can be affected by Inheritance Tax.
• Using life insurance as a tool to cover potential IHT bills.
• The benefits of placing your life insurance policy “in trust” to minimise Inheritance Tax.
• Other effective ways to reduce Inheritance Tax through gifting.

Inheritance Tax rates and limits

Inheritance Tax is a tax on the value of a person’s estate when they die. Your estate includes everything you own, such as:

• Property
• Savings and investments
• Money
• Personal possessions
• Life insurance payouts not placed in trust

If you have assets you want to leave to your family or friends, you will need to consider if IHT could be due.

The standard Inheritance Tax rate is 40%. However, it is only charged on the portion of your estate that is above the tax-free threshold. Currently, if your estate is worth over £325,000, it may be taxed at 40%.

Example:

If your estate is worth £400,000, you would only pay tax on £75,000 (£400,000 minus the £325,000 threshold). This would mean £30,000 of tax would be payable (£75,000 x 40%).

Inheritance Tax is paid from your estate. The person dealing with your estate (or the executor of your will, if you have one) will pay the tax due to HM Revenue and Customs (HMRC).

Inheritance Tax allowances and exemptions

There are ways to increase your IHT-free allowance:

• Nil-rate band: Everyone has a £325,000 IHT-free allowance. If your estate is below this amount, no IHT is payable.
• Spouse or civil partner exemption: Anything left to a spouse or civil partner is exempt from IHT, regardless of the estate’s value. This exemption does not apply to unmarried couples. You can give your spouse or civil partner as much as you like during your lifetime, if they are a permanent UK resident.
• Residence nil-rate band: If you leave your main home to direct descendants (children, grandchildren, stepchildren, adopted children, or foster children), you may receive an additional allowance of up to £175,000. This is in addition to the current £325,000 nil-rate band.

It’s important to note that proposed changes for the 2027/28 tax year mean unused pensions may be included in your estate for inheritance tax purposes.

For more details on thresholds, rates, and relief, see the GOV.UK Inheritance Tax guidance.

Life Insurance and Inheritance Tax

Without careful planning, life insurance payouts can increase the IHT your beneficiaries owe. Many people wonder how life insurance inheritance tax works and how it might affect their loved ones. Understanding these rules is key for effective estate planning.

How Life Insurance affects Inheritance Tax

Life insurance payouts are usually included in your estate for IHT purposes. If the payout pushes your estate over the tax-free threshold, your beneficiaries may have to pay 40% tax on the additional amount.

Using Life Insurance to cover Inheritance Tax

Life insurance can help cover potential IHT bills. You can calculate your potential IHT liability and choose a life insurance policy with a payout that covers it.

Whole-of-life insurance is often used for this purpose. This policy guarantees a payout whenever you die, unlike term life insurance, which only pays out if death occurs within a specified term. A whole-of-life policy, particularly when written in trust, can provide funds to cover IHT due on your estate.

How to reduce Inheritance Tax on Life Insurance

An effective way to prevent IHT being charged on your life insurance is to write your policy “in trust”.

A trust is a legal arrangement where you give your policy to trustees who look after it for your beneficiaries. When written in trust:

• The payout does not form part of your estate.
• The money is not subject to Inheritance Tax.
• Beneficiaries receive the money more quickly, bypassing probate.
• You can choose exactly who gets the money.

There are different types of trusts, and you should seek professional advice to choose the right one for your circumstances.

Who should place Life Insurance in a Trust?

Consider placing your life insurance in a trust if you are:

• Someone with an estate near or over the IHT threshold.
• A homeowner.
• Anyone who wants to ensure their life insurance benefits go directly to beneficiaries without issues or delays.

Consequences of not using a Trust for Life Insurance

If your life insurance policy isn’t in a trust, the payout is added to your estate. This can:

• Push your estate over the IHT threshold, leading to a tax bill for your beneficiaries.
• Cause probate delays, preventing your family from accessing the money promptly.
• Result in your beneficiaries receiving less than you intended due to taxes.

Here’s a comparison:

How to set up a Life Insurance Trust

Here are some useful tips on how you might get started:

1. Choose a trust type: You can speak to a financial adviser who can help you find the right trust.
2. Appoint trustees: You can select family members or close friends to manage the trust.
3. Create documents: You can work with a legal professional to help you prepare the necessary trust documents.
4. Inform your insurer: Let your life insurance provider know that your policy is held in trust.

Most insurance providers offer trust options when you take out a policy, often at no extra cost. If you already have a policy, you can usually still place it in trust. Contact your provider for their trust forms.

Shepherds Friendly’s Over 50s Life Insurance can assist with your end-of-life expenses.

Other ways to reduce Inheritance Tax through gifting

You can also reduce your estate’s value with gifts. A ‘gift’ can include anything that has value, including money, property, or possessions.

The following are exempt from Inheritance Tax:

• Gifts to a spouse or civil partner if they are a permanent UK resident.
• You can use your Annual Gift Allowance to save for grandchildren, if you have them.
• Small gifts up to £250 per person per tax year.
• You can give away £3,000 each tax year.
• Wedding gifts up to certain limits.
• You can make donations to registered charities.

A summary of life insurance inheritance tax rules

• IHT is due on estates over a certain amount, but there are allowances and exemptions.
• Life insurance payouts may be subject to IHT.
• Placing life insurance in trust and making certain gifts can help to reduce IHT.
• Always seek professional financial advice for estate planning.

Important: Tax rules can change, and everyone’s situations are different. This article provides general information and is not personal advice. We recommend speaking to a financial adviser before taking out a plan.

Explore Shepherds Friendly’s Over 50s Life Insurance or check out the Shepherds Friendly blog for more information.