Giving our family and loved ones financial security is one of the most valuable things we can do when we die. People do this in many ways, with leaving an inheritance and taking out life insurance among the most common.
An important thing to consider when doing this is making sure they aren’t faced with a hefty inheritance tax (IHT) bill upon your passing. You may have already thought about how a life insurance policy can help you with this. This article will give you an understanding of how and when IHT might apply to a life insurance policy.
What Is Inheritance Tax?
When someone passes and leaves an estate to their next of kin, the recipient of the estate may be liable for paying tax on what they receive. Whether or not they’re liable will depend on the amount they receive. Only a small percentage of estates tend to incur IHT. However, it’s worth knowing how it works and considering it when drawing up your will.
When Inheritance Tax Applies to Life Insurance
If an estate equates to more than £325,000 (£650,000 if you’re married or widowed), it will become liable for inheritance tax. Once your estate reaches this threshold, they will have to pay 40% IHT on the value above the £325,000 threshold.
For instance, if your estate is worth £600,000, it is £275,000 above the IHT threshold. The beneficiaries of your estate would need to pay 40% on £275,000, equating to £110,000. This is irrespective of which tax bracket the recipient is in. Hence, why only a small percentage of estates incur inheritance tax.
The same rule applies to your life insurance policy. If the overall payout goes above the IHT threshold, your beneficiaries will need to pay IHT. Therefore, considering IHT when arranging your life insurance can be pivotal to what your loved ones will inherit.
If you leave your home to your next of kin, there is a slightly higher threshold, £425,000, before IHT applies.
When Inheritance Tax Doesn’t Apply to Life Insurance
Usually, for beneficiaries to receive life insurance payouts, they would need to claim via your insurer. In these circumstances, the standard 40% IHT would apply. One way to avoid this is for you to arrange for your life insurance payouts to go directly to the beneficiary.
Another way to reduce IHT is to take out life insurance to cover the potential IHT liability.
How Life Insurance Can Be Protected to Ensure It’s Not Subject to IHT
You can protect your life insurance by separating the payout from your overall estate, by putting your life insurance policy in trust. By doing this, it no longer forms part of your estate. This may help to stop the total value of your estate from going above the £325,000 IHT threshold.
When you create a trust, you enter a legal arrangement where you can give your policy over to trustees. The trustees are an independent board of people who will have the legal obligation to dispense the money as asked, upon your death. Until then, they become the legal owners and keep the money secure for your beneficiaries.
To set up a trust is quite simple and usually free. Ask your insurer if they can help you do this. Ideally, you would set up the trust upon first taking out the cover but can do this at any time.
Putting your life insurance into a trust can take away some of the stress of having to handle the finances of the person they’ve lost.
Other Advantages of Using a Trust
In addition to being able to manage who receives payouts from your life insurance policy, it also enables them to be made faster. Because it’s no longer legally considered part of your estate, the extensive proceedings (i.e. probates) that usually come with sharing out an estate, no longer applies. That means it’s more straightforward for your beneficiaries to receive the money you’ve intended for them.
Possible Disadvantages of Using a Trust
Using life insurance to avoid IHT may not necessarily be the best choice in every situation, and there are several crucial factors to consider. Trusts have specific legal concepts which can be complicated. Plus, once you put your money into the trust, although you can dictate the terms of how that trust is managed, you will effectively no longer have control of it.
What to Consider When Taking Out Life Insurance
If you have a non-qualifying insurance policy, meaning it includes an investment bond, your income tax and rates on the life insurance payout may be higher. In these instances, tax can become complicated to navigate, so do speak to your insurer or a specialist advisor to find out more about what a non-qualifying insurance policy is.
Another thing to consider when taking out life insurance is your age. In theory, you can get life insurance at any point in your life. However, the majority of insurance companies have an upper age limit of 80 and may not accept applications for Life Insurance beyond this. There are also a small number of companies, such as Prudential Finance, who stop offering insurance once you reach 75.
If you are above 80, you do still have a few options available, such as whole life insurance. These policies usually cover burial insurance plans and final expense insurance to help your family cover funeral costs.
However, it's important to remember that the later in life you wait to take out life insurance, the higher the premiums will be. And the more likely that policies at your disposal will become less desirable.
You can certainly use your life insurance to prevent beneficiaries from having to pay for IHT. It's essential to seek out all your options, fully understanding the terms of each one, to make the best decision for you and your loved ones.