Do you pay inheritance tax on life insurance?

Life insurance is a way to financially protect your loved ones should the worst happen to you. But you might be asking yourself about tax deductions on the pay out.

Keep reading this guide to find out everything you need to know about life insurance and inheritance tax.

Yes, your life insurance pay out could be subject to inheritance tax when you die.

Do you pay inheritance tax on life insurance?

Whether you're charged inheritance tax and how much, depends on your personal circumstances.

Currently in the UK if your estate (the value of things you own during your lifetime, such as possessions, savings and property) exceeds the value of £325,000 then you're charged 40% inheritance tax. Inheritance tax won’t be charged on life insurance if:

• Your estate is under £325,000: This is the tax-free threshold. If your estate is under this amount (including the value of your life insurance policy) then you won't be charged inheritance tax.
• You write your policy in trust: If you write your life insurance policy in trust it separates your pay out from your estate when you die, meaning it won’t be liable for inheritance tax. Instead, a trustee (of your choosing) will become responsible for your policy and will distribute the pay out as per your wishes.

You can check the government website for the most up to date rules and regulations on inheritance tax.

Is life insurance part of an estate?

Yes, your life insurance pay out forms part of your estate if you die while your policy is active.

Your estate is made up of everything you own during your lifetime - your savings, property and assets.

If your life insurance pay out is added to your estate, it could easily take it over the tax-free threshold of £325,000. That means your loved ones could pay inheritance tax.

It’s possible to separate your policy from your estate by writing it in trust.

When you write your policy in trust, the rights of the policy get passed over to a trustee (someone of your choosing). When you die, they will be responsible for splitting the money between your beneficiaries.

Can you buy life insurance against inheritance tax?

Yes, many people buy life insurance to cover inheritance tax.

Whole of life insurance is a popular choice for paying inheritance tax off as it lasts for life (meaning it’s a form of life assurance) and a pay out is made when you die. This is different to level term life insurance or decreasing term life insurance which covers you if you die within the policy term.

The policy would need to be written in trust to ensure that the money from the pay out doesn’t form part of your estate after your death.

Separating your pay out from your estate ensures that the pay out doesn’t get caught up in the probate process, which is managing and distributing the assets from an estate. This means it won’t incur inheritance tax.

Your loved ones will get a quicker pay out with this option compared to a policy that's not written in trust. They should have the funds available to help cover any inheritance tax bills on your estate.

Should I write my life insurance in trust?

If you’re looking at buying life insurance as part of your inheritance tax planning, writing your policy in trust is an essential part of protecting your loved ones.

The process of writing your policy in trust means that your pay out won’t become part of your estate when you die, offering the following benefits:

• Avoid inheritance tax: If your pay out is separate from your estate, your loved ones won’t have to pay inheritance tax on the funds, meaning they get a fuller pay out.
• Avoid probate: Probate can be a lengthy process (typically the process takes 6 – 12 months), meaning your loved ones would need to wait before they can access the pay out. If your pay out is separate from your estate, it won’t need to go through this process, giving your loved ones a quicker pay out.
• Specify your wishes: Without writing your policy in trust, the pay out is added to your estate after your death. This means it could be used to pay off unsettled debts before it gets to your loved ones. When you write your policy in trust, you can specify exactly who you would like to benefit and how much each person should get.

How do I write life insurance in trust?

Writing your policy in trust is a free and straight-forward process. It’s offered by most insurers, and you should be asked if you’d like to write your policy in trust during the application process.

You’ll need to fill in a trust form which specifies your wishes. Such as, who you’d like to name as your trustee(s) and who you’d like to name as your beneficiaries (who will receive the pay out).

You’ll also need to establish which type of trust the policy will be written in. You've got a few options but it depends on what your insurer offers:

• Discretionary trust: You give a list of potential beneficiaries and the trustee uses their discretion to split the pay out between them. You can specify how you’d like your pay out to be split but, ultimately, it’s up to the trustee. You can add to your list of beneficiaries if you need to. For example if you have children and would like them to benefit from the pay out).
• Absolute trust: You decide who you would like to benefit from the pay out and how it's split between them. You won’t be able to make any changes to these decisions.
• Flexible trust: You name your beneficiaries, these are known as ‘default’ beneficiaries. You can also name potential beneficiaries who you might want to benefit in the future, for example, children or grandchildren. Your trustee can change the default beneficiaries and can also change how the pay out is split.
• Survivor’s discretionary trust: Typically available with joint life insurance policies. It offers a ‘survivorship’ option meaning the surviving partner of a joint policy benefits from the pay out before any of the other beneficiaries.

We have a guide on writing your life insurance in trust if you need more information.

Life insurance and inheritance tax planning: Key takeaways

It's important to remember:

• Your life insurance pay out will become part of your estate and could be subject to inheritance tax unless you write your policy in trust.
• Writing your policy in trust separates your pay out from your estate so your loved ones receive a fuller and faster pay out.
• The tax-free threshold for an estate is £325,000. If your estate is valued at below this amount, it won’t be subject to inheritance tax. If your estate is above this threshold, you'll be charged 40% inheritance tax.
• Writing your policy in trust is a free process that's offered by most insurers. Insurers that offer this option ask if you want your policy to be written in trust during the application process.
• Whole of life insurance is a popular choice for protecting loved ones from inheritance tax as cover lasts for life and a pay out is guaranteed.
• Don’t be afraid to ask for help. Enlisting the help of a financial advisor can help you understand life insurance, inheritance tax and how best to financially plan for the future.