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Life insurance and Inheritance Tax – how protection can ensure you leave more to your loved ones

Life insurance and Inheritance Tax – how protection can ensure you leave more to your loved ones

Nov 17, 2021

Inheritance Tax (IHT) is often called “Britain’s most-hated tax”. Payable on the value of your estate when you die, the tax can significantly reduce the legacy you leave to your loved ones.

In the 2018/19 tax year around 1 in 27 UK deaths – more than 22,000 – resulted in an IHT charge. HMRC took an eye-watering £5.4 billion of tax in 2018/19. That’s more than £5 billion of wealth that has been taken in tax rather than passed down to family or friends.

If you’re worried about a possible IHT bill, life insurance can be one way that you can ensure you pass the full value of your estate to your beneficiaries.

Before we look at how, here’s how IHT works and whether it’s likely to affect you.


IHT is payable on the value of your estate when you die

You pay IHT on the part of your estate that exceeds the tax-free threshold. In the 2021/22 tax year – and until 2026 – this “nil-rate band” amount is £325,000.

So, if you die and the value of your estate is less than £325,000, you will have no IHT to pay.

It is worth noting that any unused nil-rate band can be transferred to a surviving partner on death. This has the effect of potentially doubling the available tax-free amount to £650,000.

An additional band, known as the “residence nil-rate band” allows you to pass your home to your children or grandchildren. In the 2021/22 tax year, and frozen until 2026 – this is £175,000.

You should be aware that, if the value of your estate exceeds £2 million, the residence nil-rate band is tapered by £1 for every £2 above the £2 million limit. So, the additional allowance effectively ceases to exist if your estate is worth more than £2.35 million.

What this all means is that, if you want to pass your home to a child or grandchild, you won’t pay any IHT if the value of your estate is less than £500,000.

If it is over £500,000 then you may have a tax bill on death. IHT is charged at a rate of 40%, so it could be a sizeable amount if you don’t take steps to mitigate your tax liability.


Life insurance can help you to pass more to your loved ones

If you do think you may have an IHT liability when you die, life insurance may be one way to deal with the problem.

This is particularly true because the tax must be paid before your loved ones will be able to access your estate when you die.

If you know that your beneficiaries will be liable for IHT when you die, you could take out a life insurance policy to cover the full amount of the IHT bill. A “whole of life” policy will pay out whenever you die, rather than within a specified term (as with term insurance).

Taking out life cover for the amount of IHT you owe, and ensuring the payout from the insurance stays outside of your estate (more of this in a moment), means two things:

  • The money from the life insurance payout can be used to settle the IHT liability, ensuring your beneficiaries receive the full value of your estate.
  • Typically, the tax liability can be settled more quickly, which means loved ones could receive their inheritance sooner.

Always speak with a financial planner to ensure your life cover is structured correctly, as not doing so could land your loved ones with an even greater IHT liability. Here’s why.


Important: your life insurance needs to be written in trust

When calculating the value of your estate on death, many different types of assets contribute towards the total. This includes:

  • Property, including your home, any second homes, and any buy-to-let properties
  • Cash
  • Bank and building society savings
  • Investments
  • Personal possessions
  • National Savings & Investments, such as Premium Bonds
  • The payout from a life insurance policy.

It’s the last part here that can cause an issue. If the proceeds from your life insurance policy take your estate above the £325,000 IHT threshold, the portion of your estate above this will be liable to tax at the 40% rate.

This could result in a significant sum being removed from the pot of money that would have otherwise financially supported your loved ones upon your death.

Fortunately, however, there are ways that your beneficiaries can avoid paying IHT on your life insurance payout.

The simplest way to avoid IHT being charged on life insurance is to put your policy “in trust”.

A trust is a legal arrangement that appoints trustees, such as a solicitor, family members or friends, to look after the policy on behalf of your beneficiaries until such a time as the beneficiary is intended to benefit.

Importantly, writing your life insurance policy in trust means the payout will go directly to your beneficiaries, rather than forming part of your legal estate, and thus no IHT will be due.

Read more about the value of putting your life insurance in trust.

There are many other benefits of writing a life insurance policy in trust, too.

Firstly, it will enable you to decide who will be your trustees and who will receive the money from your life insurance policy. Setting up a trust can be particularly important if you’re not married or in a civil partnership as it will ensure your assets go to the people you want.

Additionally, writing your policy in trust also means the payout will reach your loved ones much quicker. That’s because it bypasses probate – the legal process of sorting out a deceased person’s estate.

Setting up a trust is easy and typically doesn’t cost you extra. Your life insurance provider will normally be able to help, and it usually requires nothing more than a signature on your part. While it’s generally better to set up a trust when you first put your life insurance in place, you can put your policy in trust at any time.


Speak to the life insurance experts

If your estate is worth more than the nil-rate band – £325,000 (or £500,000 if you plan to leave your home to direct descendants) – putting life insurance in place can help your loved ones to meet the tax bill without the proceeds coming from your estate.

It means your loved ones don’t have to sell valuable assets in order to pay the tax, and that they will benefit from all of your hard-earned wealth.

As we have seen, though, it’s vital that you set up the policy correctly otherwise you could actually make the problem worse.

Recent data from HM Revenue & Customs shows that more than 6,000 estates paid IHT on the payouts from life insurance policies in 2018/19 because they failed to place them in trust.

Of the 22,100 estates that paid IHT in 2018/19, the figures show that more than a quarter of them (6,040) included life insurance policies. These policies were worth a total of £709 million, which means that more than £280 million of IHT could have been paid on them.

We can work with you to find the right level of cover for your needs, and ensure that the policy is placed in trust to ensure it bypasses your estate for IHT purposes.

Contact one of our experts to find out more.


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