Life insurance and Inheritance Tax: Your questions answered

It is a horrible thought, but what would happen to you and your family if you became seriously ill or died prematurely?

Life insurance and critical illness insurance are two ways to mitigate the financial impact – but they are only part of the jigsaw.

What many people don’t consider is the Inheritance Tax (IHT) implications of a pay-out.

Without proper planning, up to 40% of that lump sum could be going to the tax man.

What is Inheritance Tax?

IHT is a tax on the property, money, assets and possessions you leave behind after all other debts and funeral expenses have been deducted.

At present, everyone has a tax-free IHT allowance of £325,000. This is usually referred to as the nil-rate band. The standard inheritance tax rate is 40% of anything in your estate over the £325,000 threshold. Married couples or civil partners can leave more than this before paying tax. 

What are the Inheritance Tax rules for married couples?

There are major benefits to being married or in a civil partnership when it comes to IHT.  Transfers between married couples and civil partners are not usually subject to IHT so if the first partner to die leaves their entire estate to the other, no tax will be payable.

It's also likely that none of their nil-rate band has been used, and the partner will be able to add the unused balance to their own, effectively doubling the threshold. However, there is one thing to consider - if your partner has left bequests to others (and lifetime gifts made within seven years of death), their estate may attract IHT if it's large enough and may use up some or all of the nil-rate band.

Do I have to pay taxes on life insurance?

While there is no specific tax on life insurance, either when you buy or in the event of a valid death claim, the value of your life insurance policy may be subject to Inheritance Tax if it forms part of your estate. So, potentially, yes is the answer.

How can I protect my pay-out?

One option is to speak to a solicitor about putting your life insurance into a trust. This is a legal arrangement that lets you leave assets to friends, family or whomever you choose to be your beneficiary, and will not be considered part of your estate so it won't be subject to tax on the value of your life insurance.

You can choose any person, or people, to be your beneficiaries - this will entitle them to receive a pay out in the event a valid claim is made. Contrary to what some people may assume, there are no rules that restrict who your life insurance beneficiary can be.

What do the experts say?

Aileen Entwistle, a Partner in Aberdein Considine’s Private Client team, said: “It is really easy to jump online and take out a life insurance or critical illness policy.

“However, this is a critical stage of wealth and estate planning, where expert advice can make a huge difference to your family or those you leave behind.

“As both a wealth adviser and a legal firm, we can help you get the right level of protection in place, as well as the right legal mechanisms to minimise your Inheritance Tax bill.”

Speak to us

Click here if you would like to speak to us about protection or Inheritance Tax planning.

Click here to download our full guide to Inheritance Tax planning.

This article was written in August 2021 and based on the tax regime in place at the time. This guide is for your general information and use only, and is not intended to address your particular requirements. The content should not be relied upon in its entirety and shall not be deemed to be, or constitute, advice. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future.