Life insurance and inheritance tax

There are ways to minimise how much inheritance tax you pay on your life insurance payout and make sure you leave your loved ones with as much as possible

goco author
Updated 16 September 2021  | 6 min read

Key points

  • If the value of your estate is over £325,000, anything above this will be liable for 40% inheritance tax
  • You can reduce the amount of inheritance tax you pay by writing your life insurance into trust
  • If you’re married or in a civil partnership, you can double your inheritance tax-free amount by pooling your allowances
  • Making gifts and financial transfers during your lifetime is one way of helping to cut your inheritance tax

What is inheritance tax?

Inheritance tax is the money the government takes from your property, savings and possessions that you own when you die - together these are known as your estate. 

You need to pay inheritance tax once the value of your estate reaches the inheritance tax threshold. Anything over this amount will be subject to 40% tax.

If the value of your estate is more than the threshold, the loved ones you leave behind could end up receiving far less than you or they expected.

What is the nil-rate band?

The inheritance tax threshold is £325,000 - this is called the nil-rate band. You don’t have to pay inheritance tax on any estate that falls under this threshold.

If your estate is more than the tax threshold and you own a property, you may also be able to benefit from the residence nil-rate band of £175,000. This rate rises each year with inflation.

Do you pay inheritance tax on life insurance?

If the payout from your policy forms part of your estate, you’ll need to pay inheritance tax on anything over the £325,000 threshold.

What other taxes might impact life insurance?

When your life insurance policy pays out, the money will be tax-free. 

However, there are a few situations where tax may still apply, these include:

  • If any interest has been earned on the lump sum - this might happen if there’s a delay between the death of the policyholder and the beneficiaries receiving the money
  • If your life insurance policy is used as a form of investment - these policies are known as non-qualifying and don’t qualify for any income-tax relief 

How does inheritance tax work for married couples?

In most cases, married couples and civil partners can pass on their entire estates directly to each other when they die, without having to pay inheritance tax.

Because of this, it’s likely that they won’t have used any of their nil-rate allowance. When this happens, the surviving partner can add the unused balance to their own. 

This can double their tax-free allowance for the estate they’ll leave behind when they in turn pass away.

It’s possible to pool both your nil-rate inheritance tax allowance and your residence nil-rate allowance - which means you could pass on up to £1m tax-free.

Putting life insurance ‘in trust’

One way to minimise the inheritance tax you pay is to write your life insurance into trust.

By doing this you transfer the ownership of the life insurance trust to trustees. They’ll be responsible for looking after and distributing the policy payout according to your wishes.

Instead of forming part of your estate, the life insurance payout is paid directly to the trust and so is not subject to any inheritance tax.

Putting your life insurance into trust also means your beneficiaries could receive the money more quickly and will avoid having to wait to go through probate.

Is it possible to avoid inheritance tax?

If your estate’s value is over the threshold when you die you can’t avoid inheritance tax, but there are things you can do beforehand to help reduce what you pay, these include:

  • Giving assets away before you die - If you live for seven years after gifting them, you can avoid inheritance tax. If you die within seven years, inheritance tax will be calculated on a reducing scale that lessens with every year passed since you gave the gift.
  • Using your annual exemption - you can give a total of £3,000 of gifts away each year without them being included as part of your estate. If you don’t use your annual exemption one year, you can carry it forward to the next tax year.
  • Giving a £5,000 wedding gift and multiple gifts of £250 - you can give your child or grandchild a wedding gift of up to £5,000. You can also give multiple gifts of £250 per person, but you can’t use your annual exemption for the same person.
  • Regularly giving from your surplus income - the payments have to be regular, like paying monthly into your child’s savings account and you need to keep accurate records of these gifts, so it’s a good idea to speak to a legal or tax advisor.
  • Leaving money to charity - anything you leave to charity will be free of inheritance tax and if you leave at least 10% of your total assets to charity, the inheritance tax on the remaining estate will be reduced from 40% to 36%.

Can I use life insurance to pay inheritance tax?

If you want to help pay for your inheritance tax, you can take out a whole-of-life insurance policy. This is a type of life cover that pays out a lump sum when you die, whatever your age.

To make sure the proceeds from the policy can be used to pay for inheritance tax, you need to write your policy into trust so that it doesn’t form part of your estate.

By paying regular premiums until you die, a whole-of-life policy also has the benefit of helping to reduce the value of your estate and how much it will be over the tax threshold.

What else do I need to know about life insurance and tax?

When you take out life insurance it’s a good idea to try and calculate how much inheritance tax your family and loved ones will need to pay when you pass away.

Your life insurance can help to cover this bill as well as helping towards paying for things like any outstanding debts you have and your funeral expenses.

Working this out can help you decide what type of policy you choose and the level of cover you take out

If your finances are complicated, speak to an independent financial advisor who can explain the options and advise on what might work best for your needs.