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
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.
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.
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.
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:
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.
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.
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:
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.
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.