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Understanding life insurance and tax
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Providing your beneficiaries makes a successful claim, life insurance could provide them with a lump sum should you die unexpectedly. To help cover things like mortgage repayments, childcare or everyday living costs.
Although there’s no direct tax on life insurance, inheritance tax could apply to all assets that form part of the estate. And that could include any potential life insurance payout.
In that situation, your life insurance payout would be subject to the inheritance tax allowance set by the government. Anything above this threshold may be subject to inheritance tax, reducing the intended payout for your loved ones.
Depending on the potential value of your estate, you could consider holding some of your assets in a trust. Included in this can be life insurance policies.
In the event of your passing control of a trust can be transferred from you to another person. Legally, the trust will be viewed as separate from your estate, so would be exempt from inheritance tax. That could mean your loved ones will pay less tax and receive more of your life insurance payout.
What is an estate?
When someone dies, everything they leave behind is referred to as their ‘estate’. This can include:
- Assets, and possessions such as property, money and investments, vehicles, pets and other valuables.
- Liabilities, such as mortgage, credit card or loan balances.
Inheritance tax may be payable when an estate is valued over a certain threshold, set by the government.
What is inheritance tax?
The current threshold for inheritance tax is £325,000. If the value of your estate is above that, anything over that figure may be subject to the standard rate of inheritance tax of 40%.
Exceptions apply. For example, inheritance tax may not apply to:
- Estates valued below the £325,000 threshold.
- Anything above the £325,000 threshold that is left to your partner, spouse or a charity.
The threshold for inheritance tax can also increase to £500,000 if you leave your home to your children or grandchildren.
It’s worth knowing that inheritance tax can also apply to gifts made by the deceased in their lifetime. These are subject to tax exemptions and relief.
It is the responsibility of the estate administrator or executor to work out and pay the right amount of inheritance tax. If there’s a life insurance payout, this won’t be taxed at the source. But its value may go towards the inheritance tax threshold.
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No, a life insurance payout is not directly taxable. If, however your life insurance policy is not written in a trust then it will form part of your estate. Its value will go towards your inheritance tax threshold of £325,000.
Working out the value of your estate could help you make decisions about your finances and protect your family. For example, you may consider transferring some of your assets into a trust. This will help you to limit the future impact of inheritance tax.
Think about the value of:
- Your property.
- Bank accounts.
- Personal possessions, like your household contents, cars and jewellery.
- Life insurance policies.
- Pensions.
- Bonds.
You should take off things like loans and credit card balances from this value.
Now you’ve worked out the potential value of your estate, does it exceed the inheritance tax threshold of £325,000?
If your property is worth less than £2 million and you leave it to a child or grandchild, you’ll get an extra tax-free allowance of £175,000. This brings your threshold to £500,000.
Anything over and above the applicable threshold may be subject to inheritance tax, at a standard rate of 40%.
Other forms of insurance
If you make a successful claim against another form of policy, like critical illness cover or income protection, you could receive a payout yourself. This means the money is there for you to spend on your needs. Such as mortgage repayments, living costs or making changes to your home.
Inheritance tax won’t apply, unless the payout becomes part of an estate you eventually pass on, or unless your beneficiaries receive the payout after your death.
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If you have concerns that inheritance tax will eat into the benefit you’d like to leave for your loved ones, you may like to think about:
Putting assets into a trust
You could put assets, including life insurance policies, into a trust. In the event of your death, legal control could be passed to your beneficiaries. Most importantly, the trust will be viewed separately from your estate, so anything held within it won’t be subject to inheritance tax. Your beneficiaries may also be able to claim and receive a payout faster.
Couples and inheritance tax
Leaving your primary home to your spouse means its value won’t go towards your inheritance tax allowance. Married people get twice the inheritance tax allowance in the event of their spouse passing away – £650,000 in total.
For couples who plan to leave their home to their children or grandchildren, the inheritance tax threshold could be higher still. Accounting for the combined inheritance tax threshold and Residence Nil Rate Band (RNRB) for both partners, the tax-free allowance could be as high as £1 million.
Inheritance tax and gifts
It’s permitted to give financial gifts to your loved ones of up to £3,000 each year. This could reduce your overall estate value and limit the tax due on it – or negate inheritance tax altogether. Just be aware that any gifts given within 7 years of your death could still be considered part of your estate and must be declared to tax authorities.
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Below are 3 examples illustrating how inheritance tax could affect your estate:
- Your estate – your home, cars, money and other possessions – comes to £400,000. You also have a life insurance policy with a value of £100,000. On your death, the total value of £500,000 exceeds your £325,000 threshold by £175,000. This excess is taxed at 40%, or £70,000. In this example, your beneficiaries would be left with £430,000.
- Your estate is worth £500,000, but £250,000 of this is the value of your house. You leave your house to your children, leaving other assets worth £250,000. This is below the inheritance tax threshold, so no tax would be due.
- You leave your entire estate to your spouse or civil partner. This means that no inheritance tax applies, even to anything over the £325,000 threshold.
Let’s look at the details
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If the value of the estate you leave behind is lower than the current inheritance tax threshold of £325,000, tax wouldn’t apply.
If your estate may be worth more than that, accounting for things like potential life insurance payouts, you may consider placing some of your assets in a trust. This could help you and your beneficiaries to limit the future impact of inheritance tax.
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No, an estate left to a spouse or partner is exempt from inheritance tax. This is the case regardless of the estate’s value. So, even if it’s over the inheritance tax threshold, it will still be tax-free.
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Once a valid life insurance claim is made and approved, a payout will be made to the deceased’s beneficiaries. It’s important for the executor of the deceased’s Will to be aware of this. It’s their responsibility to declare and pay any due taxes and make sure fair distribution of estate assets.
If the life insurance policy is in trust, any payout will be made to the trustees. They’ll be responsible for distributing these funds to all named beneficiaries.