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Life insurance and inheritance tax explained

In this guide, we will explain inheritance tax and the inheritance tax threshold. We will also explain how to use a life insurance policy to pay an inheritance tax bill.

We also cover how you can use a trust so that you don’t need to pay inheritance tax on a life insurance payout.

What is inheritance tax and how does it work?

Inheritance tax is a tax on the estate of someone who has died. Your estate is made up of all the things you own. This includes your home and car, your savings and investments, and your personal belongings. These belongings include jewellery, art, and furniture. It can also include a life insurance payout.

Not everyone has to pay inheritance tax. If your estate is worth less than £325,000 when you die, whoever is dealing with your estate won’t have to pay any inheritance tax. Any amount above this inheritance tax threshold could be taxed. The amount up to £325,000 is known as the ‘nil rate band’ because the inheritance tax you pay is nil if you stay below it.

You can also pass on up to £175,000 more, free from inheritance tax, if you leave your share of your main home to your children or grandchildren. This amount is known as the ‘residence nil rate band’. Together, these two nil rate bands add up to £500,000 per person.

When you’re working out if you need to pay inheritance tax, remember that spouses and civil partners don't need to pay it. You can pass on your £325,000 inheritance tax allowance and the £175,000 residence inheritance tax allowance to your partner. This gives them an extra allowance of up to £500,000 after you’ve died. 

How much inheritance tax do I have to pay?

If your estate is worth more than the thresholds, any amount over those thresholds will be taxed at 40%.

To explain, let’s take a look at Sadie and Oscar as an example of how much inheritance tax you may have to pay.

Sadie’s inheritance tax liability 

Sadie is divorced and has a home valued at £550,000. She also has savings, personal belongings and a life insurance policy that are worth a total of £300,000. Sadie has three children, and she wants them to share her estate equally. 

  • Sadie’s total estate = £850,000
  • Nil rate band allowances = £500,000.  
  • Estate liable for inheritance tax = £850,000-£500,000 = £350,000  
  • Inheritance tax = £350,000 x 40% = £140,000
  • Sadie’s estate = £850,000 - £140,000 (inheritance tax) = £710,000 
  • Sadie’s estate is then shared between her three children. They inherit £236,000 each. 

Oscar’s inheritance tax liability 

Oscar is a widower and has a home valued at £550,000. His savings, personal belongings and a life insurance policy are also worth a total of £300,000. Oscar wants his three children to share the estate equally as well. 

  • Oscar’s total estate = £850,000  
  • Nil rate band allowances = £500,000, plus his partner’s allowances of £500,000 = £1 million 
  • Estate liable for inheritance tax = £1million - £850,000 
  • Oscar’s estate is not liable for inheritance tax because he falls within the nil rate band allowances. 
  • Oscar’s three children inherit over £283,000 each. 

Is a life insurance payout considered part of my estate?

Unless you put your insurance policy into trust, any life insurance payout on your death will become part of your estate. It could be subject to inheritance tax if your estate is greater than the tax thresholds.

A trust removes your insurance policy from your estate. So your beneficiaries won’t need to pay tax on it. A legal agreement is set up so that the trustees, who run the trust, become the policy's legal owners. This means it no longer belongs to you. As part of the trust, you can request that certain people, such as your family, benefit from the payout. The trustees are required to follow your request when you die.

You can set up a trust when you first take out your life insurance. Insurance providers can usually help you out with that.

Can I use a life insurance policy to pay inheritance tax? 

Yes, you can. If you put your life insurance policy in trust, it’s owned by the trustees and sits outside of your estate. This means it can be paid out straightaway, free of all taxes and without waiting for probate. It can then be used to pay all or some of your inheritance tax bill if you have one or be paid to your beneficiaries for them to use as they wish. 

Probate is the legal right to handle someone’s estate. Executors of a will often need to apply for probate before they can access the deceased’s finances. Probate can take 16 weeks to come through and longer if extra information is needed.  

Inheritance tax usually needs to be paid within six months of the date the person died. By using a life insurance policy in trust, the money to pay an inheritance tax bill is available much sooner than if the estate had to go through probate. 

Why put a life insurance policy in trust?

When you put a life insurance policy in trust, it’s no longer counted as part of your estate. So, even if your estate is liable for inheritance tax, the life insurance policy goes to the people you choose to receive it – your beneficiaries.

They can use this amount to pay your estate’s inheritance tax bill, pay off outstanding debts or use as they wish.

The benefits of putting life insurance in trust 

There are several benefits of putting a life insurance policy in trust. Here are a few: 

Inheritance tax planning 

If you think you’ll need to pay inheritance tax on your estate when you die, you can take out an insurance policy in trust to cover the tax bill. The policy sits outside of your estate, so is not subject to probate and can be paid quickly. This means the people looking after your estate have the money available to settle your bill before the six-month time limit is up. 

Cover outstanding debts 

If you die but still have debts in place, such as a mortgage, you can place an insurance policy in a trust. That way, your loved ones will be able to repay the debts from the insurance payout rather than your inheritance, or they’ll have to sell the family home.   

Specify your wishes 

When an insurance policy is in trust, you can choose who receives the payout and the trustees will usually follow your request. For example, you can name exactly who should receive a payout or specify a group of people, like your future grandchildren. You can also nominate a charity if you want to. 

Speedy payout 

When there’s a trust in place, the trustees can make a claim, and your beneficiaries can receive the money in a few weeks. Without a trust, the payout money will be part of your estate. It will usually need to go through probate, which can take 16 weeks or more.  

How to put a life insurance policy in trust

When you first set up your life insurance policy, the insurance provider will ask you if you want to put it in trust. There are two types of trust available - discretionary and absolute trusts.   

Absolute trusts have specific beneficiaries. Their interests in the trust are fixed at the start and cannot change. If a beneficiary dies before you do, their estate will benefit when you die.  

You can set up discretionary trusts for a group of potential beneficiaries. For example, for future grandchildren. The trustees can use their discretion to benefit anyone within the group. The trustees are guided by a non-binding letter of wishes, which you write when the trust is set up.  

Once the trust is established, the trustee owns the policy. So, those dealing with your estate must tell the trustees that you’ve died. The trustee will have a copy of the trust deed and your letter of wishes. They can use these to make sure your beneficiaries receive the money you wanted them to.  

It’s important you choose the right type of trust as it can’t be changed once it’s been established. That's why we recommend you speak to a financial adviser. They can help you choose the best one for your circumstances. 

Do you have to pay tax on a life insurance payout?   

Life insurance payouts are tax free. So, your beneficiaries won’t pay income or capital gains tax on a life insurance inheritance when they receive the money.  

But, unless the life insurance policy is written in trust, the payout could become part of your estate. Then, it could become subject to inheritance tax. So, if the payout is £100,000 but your estate is subject to 40% inheritance tax, your beneficiaries may only receive £60,000.  

Once your beneficiaries receive the money, it becomes part of their estate. They'll need to see if the payout puts them over the tax threshold. If it does, they may want to take steps to minimise inheritance tax. 

Life insurance and inheritance tax – things to consider 

What type of life insurance policy should I use? 

You can put most types of life insurance into trust. But, if you want to use the life insurance payout to pay your estate’s inheritance tax, you can only do that with a whole of life policy. As the name implies, it lasts for the whole of your life and will payout when you die.   

Term life insurance pays out if you die during the term of the policy. You can choose a term between five and 70 years. This means if you die outside the policy term, you won't get a payout. You'll need to pay any inheritance tax from other sources. 

How much life insurance do I need? 

This depends on what you want your beneficiaries to do with the payout. If you're using life insurance to cover some or all your inheritance tax, you need to find out how much tax you expect to pay. Then, take out a policy for that amount and place it in trust. 

Which type of trust should I use? 

You’ll need to decide which type of trust works best for your circumstances as there are several you can choose from. We recommend that you speak to a financial adviser to help you decide.  

Who should I have as a beneficiary?

Most people have their family members or friends as beneficiaries, but you can also choose to leave your money to a charity. If you plan to use the life insurance payout to pay your inheritance tax bill, you’ll need to let your executors know this. 

Vitality life insurance

Want to know more about life insurance or thinking about taking out a policy? Here are some of the benefits of taking out life insurance with Vitality: 

  • A brand you can trust - In 2023, we paid out 99.7% of life insurance claims.* 
  • Get a discount on your monthly premiums when you add Optimiser to your plan. Receive up to 30% off when you choose term life insurance, and up 40% off when you choose whole of life insurance. 
  • Access to Vitality partner discounts and rewards. 
  • Get free no-obligation advice. Our advisers offer expert advice to help you make the right decisions.
Get your life insurance quote today
Published: 13 June 2024

*Vitality Claims and Benefits Report, 2024 

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