How Do Life Insurance Policies Affect Inheritance Tax

Understanding Inheritance Tax and life insurance

Inheritance Tax is charged on the value of your estate when you die. The standard rate is 40% on anything above the Nil Rate Band of £325,000 per person. You may also benefit from the Residence Nil Rate Band of up to £175,000 if you leave your main home to your direct descendants.

Your estate includes your property, savings, investments, and certain life insurance policies, depending on how they are arranged. If your total estate exceeds your available allowances, the excess is taxed at 40%.

The key question for life insurance is whether the payout is considered part of your estate. If it is, it increases the value of your estate and can trigger a larger IHT bill.

When life insurance is included in your estate

If your life insurance policy is held in your name and not placed in trust, the payout automatically forms part of your estate when you die.

This means:

The payout increases the total value of your estate.

It may push your estate above the tax threshold.

Your beneficiaries could receive less because part of the payout is used to pay IHT.

Example

You have an estate worth £400,000 and a life insurance policy that pays out £200,000 on your death.

Your total estate is now £600,000. After deducting your £325,000 Nil Rate Band, £275,000 is taxable at 40%, resulting in a £110,000 IHT bill.

Had the policy been written in trust, the £200,000 payout would not be part of your estate, saving £80,000 in tax.

When life insurance is excluded from your estate

The most effective way to keep your life insurance payout outside your estate is to write the policy in trust. This means the proceeds are paid directly to your chosen beneficiaries or trustees rather than forming part of your estate.

When you place a policy in trust:

The payout bypasses your estate completely.

No Inheritance Tax is due on the policy itself.

The money can be paid out quickly without waiting for probate.

Trusts are a common estate planning tool because they give you control over how and when the payout is distributed. For example, you can specify that funds go to your spouse immediately or to your children once they reach a certain age.

Types of trusts used for life insurance

The most common types of life insurance trusts include:

Bare (absolute) trust The beneficiaries are fixed, and they receive the proceeds outright when the policy pays out.

Discretionary trust The trustees decide how and when to distribute the funds among the beneficiaries you name. This provides greater flexibility.

Flexible trust Combines fixed and discretionary features, often used for family situations where circumstances may change.

Most insurance providers offer standard trust forms that can be completed at no extra cost when you take out the policy. You can also set up a trust for an existing policy, although this may require additional paperwork and professional advice.

Using life insurance to cover an Inheritance Tax bill

Another way life insurance can help with Inheritance Tax is by providing the funds needed to pay it.

If you expect your estate to exceed the tax thresholds, you can take out a policy specifically designed to cover the potential IHT bill.

Two types of policies are commonly used:

Whole-of-life insurance: Pays out whenever you die, making it suitable for covering IHT liabilities that will definitely arise.

Term life insurance: Runs for a fixed period, useful if you expect your estate’s value or tax exposure to change over time.

By placing this policy in trust, the payout can be used by your executors or beneficiaries to settle the IHT bill without increasing your estate value. This prevents them from having to sell assets or property to raise funds for tax.

Example

If your estate is valued at £900,000, leaving a £600,000 taxable balance after allowances, the IHT liability would be £240,000.

A whole-of-life policy written in trust for £240,000 ensures your beneficiaries have the cash available to pay the tax, leaving the estate intact.

Joint life insurance and Inheritance Tax

For couples, a joint life second death policy is often used for IHT planning. This type of policy pays out after both partners have died, which is when IHT becomes due.

Since transfers between spouses and civil partners are exempt from IHT, the tax only applies after the second death. A joint life policy provides funds at the exact time they are needed to pay the IHT bill on the estate.

If this policy is written in trust, the payout also stays outside the estate, ensuring the full amount is available for beneficiaries.

What happens if you change or cancel your policy

If you change ownership of your policy or move it into a trust later in life, it can sometimes be treated as a gift for IHT purposes.

This means it becomes a potentially exempt transfer (PET). If you die within seven years of making the transfer, the policy’s value could still be included in your estate for IHT.

For this reason, it’s usually better to write your policy in trust when you first take it out. This avoids triggering any PET rules and ensures the policy stays outside your estate from the start.

Premiums and Inheritance Tax

The regular premiums you pay for your life insurance are not normally subject to IHT, provided they are paid out of regular income and are reasonable in relation to your total earnings.

However, if you pay a large lump sum into a trust to cover premiums, that payment might be treated as a gift. In that case, the seven-year rule for gifts could apply.

Reviewing your policy and estate regularly

Life insurance should be reviewed regularly alongside your will and overall estate plan. Circumstances such as marriage, divorce, children, or changes in wealth can affect how your policy should be structured.

Ensure your trustees, beneficiaries, and executors know how the policy is arranged and where the documents are kept. A misplaced trust form or outdated policy can delay payments or lead to unnecessary tax.

Final thoughts

Life insurance can play a vital role in protecting your family and managing Inheritance Tax. If your policy is not written in trust, the payout may be added to your estate and taxed at 40%. By placing it in trust, you can ensure the funds go directly to your beneficiaries, free from IHT and without the need for probate.

Writing your policy in trust is usually simple and cost-free but has long-term benefits for estate planning. Combined with other allowances and strategies, it can help your loved ones receive their full inheritance quickly and without unexpected tax burdens.