Inheritance tax and life insurance are sometimes discussed together, as one can be the solution to the other. When considering death, some people will need to consider whether it will give rise to an inheritance tax bill. Inheritance tax planning can include life insurance that can pay money to be used as a possible solution for paying the bill when it arises. In this article, we explain how life insurance and inheritance tax work and when you may wish to consider buying life insurance as part of your financial planning.
Can life insurance cover Inheritance Tax?
Yes, life insurance can pay out a sum of money upon your death that could be used to pay either some or all of the inheritance tax due to HMRC when you die. However, it is one of a number of ways in which you can organise your financial affairs, so it is helpful to speak to a financial adviser* about how best to arrange your estate to mitigate inheritance tax in the first instance.
Life insurance can be used as a method of funding an inheritance tax (IHT) bill. By arranging a specific type of life insurance and putting it in a trust, upon your death, the cash from a life insurance payout is paid outside of your estate. You can nominate who you wish to leave the life insurance cash payout to so it can be used to pay the inheritance tax on your estate.
Although your family can pay an inheritance tax bill using existing funds - their own or from the assets they inherit. Unless your estate holds liquid funds which can be readily accessed to pay the inheritance tax bill, your family may find themselves facing the need to sell assets to raise the money needed to pay the inheritance tax instead. This isn't always easy or desirable and requires careful consideration, and it is often after considering these facts that people look to life insurance as a possible inheritance tax solution. Choosing life insurance as a method of protecting your estate from inheritance tax could mean that you can pass on more of your assets to your family. For the rest of this article, we will assume that you have considered all other options and, either with the help of a financial adviser or other financial professional, you have worked out that life insurance is the best solution for your circumstances.
If you are not sure whether your estate will be subject to inheritance tax, you can check this using our Inheritance Tax calculator.
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How does life insurance work to cover Inheritance Tax?
In the UK, inheritance tax is levied on estates in excess of the nil rate band which is £325,000 per person. When you die, your family or the persons who will take charge of your estate will have to apply for probate. Probate is granted after your estate is assessed by the state and this process will highlight any inheritance tax that may be required to be paid. If the net value of your estate is £325,000 or under, inheritance tax will not apply, however if it exceeds this amount, then IHT will be levied at 40% on the value over and above the nil rate band. If you pass your estate to your spouse, there is no inheritance tax to be paid, and your nil rate allowance will pass to your spouse, meaning that when they die, they can pass on up to £650,000 before inheritance tax is applicable. Other allowances and liabilities may also need to be considered to work out exactly how much inheritance tax could be chargeable on your estate - read about inheritance tax in more detail in our article, "Inheritance tax explained".
Once you know the amount that will be charged in inheritance tax, you may choose to buy life insurance so that the cash lump sum that is paid from the policy can be used to cover the IHT bill fully or in part.
When should you consider life insurance for inheritance tax protection?
- If you want to prevent the sale of your home or any other valuable asset to pay IHT
- If you want to ensure that any inheritance tax is paid without reducing the assets you leave to your beneficiaries
- If you have made substantial gifts (in excess of your inheritance tax nil rate band and allowable transfers) to friends or family in the last seven years as these are deducted on a tapered basis from your inheritance tax allowance first in the event of your death within seven years of the gift.
What type of life insurance policy do I need to pay the inheritance tax on my estate?
The type of life insurance that you should buy will depend on your unique circumstances. However, the most common type of life insurance arrangement used to protect inheritance tax is a whole of life insurance policy. As the name suggests, it is a type of life insurance that covers you for your entire life and pays out when you die regardless of when your death happens. There are circumstances whereby your tax liability may only exist for a set period of time - potentially exempt transfers would be one example of this - and you could buy term life insurance if this is the case.
Specialist life insurance policies called gift inter vivos are sometimes used to cover the inheritance tax that may arise on a potentially exempt transfer - gifts made during your lifetime - but should be compared with level-term life insurance to check if one provides better value for money than the other. You can learn more about any gifts you have made during your lifetime and how these might affect the inheritance tax payable on your estate in our article, "Inheritance tax (IHT) taper relief on gifts explained".
It is usually best to speak with a life insurance expert* to establish which type of life insurance will best suit your needs. The adviser will not charge for advice and can search life insurance quotes from across the market, taking into account your health and lifestyle.
Once you have selected the type of life insurance contract you will need, you can arrange this on a single-life basis if your estate will pass directly from you to your beneficiaries who are not your spouse or civil partner. On a single-life basis, the life insurance will pay out upon the death of the person who is insured. On the other hand, if your estate passes to your spouse or civil partner first so that inheritance tax will only apply once they also die, you can arrange a joint-life, second-death life insurance policy, which will cover your and your spouse/civil partner's lives and will pay out after both of your deaths.
It is essential that the life insurance policy is put into a trust so that upon your death, the cash payout is not returned to your estate, inflating its value and adding to the IHT bill. A trust will direct the money paid out from your life insurance directly to your nominated beneficiaries instead - this is a vital part of arranging life insurance to cover IHT.
If you buy life insurance to pay inheritance tax, you will need to use a trust to allocate the payout to your beneficiaries outside of your estate and you can read more about how and why to do this in our article, "Writing your life insurance in trust – How it works and why you should consider it". A trust is a legal arrangement and although writing your life insurance into trust to pay inheritance tax can be arranged with most life insurance companies, you should take the time to ensure that it correctly represents your wishes and is in line with any will arrangements that you make. The amount of life insurance you choose does not have to match the amount of inheritance tax payable on your estate, it can be more or less than this amount.
How to arrange life insurance for inheritance tax
If you wish to arrange life insurance to fund an inheritance tax bill, you will need to select the correct type of life insurance. If you have ascertained that your estate will be subject to inheritance tax and how much this will be you can start the process of choosing a life insurance solution based on your needs. In most cases, this will be whole of life insurance but in some instances, you may choose a term life insurance to cover the inheritance tax payable on gifts that you have made during your lifetime. If you have not calculated your inheritance tax liability based on your estate, you should arrange a FREE inheritance tax check to understand what you will need to prepare for. Inheritance tax can be a complex area of taxation and it is best to seek specialist help with this.
Once you have your inheritance tax details and understand how your estate is likely to be taxed and by how much, you should seek specialist life insurance advice. We have vetted the services of a specialist life insurance broker called LifeSearch* - it provides advice and guidance to find the best life insurance for your needs and the advisers are trained to provide specialist advice around inheritance tax life insurance. LifeSearch advisers will also provide all of the advice and support you need when putting your life insurance in a trust without charging a fee.
You can arrange a call with a LifeSearch adviser* to discuss your circumstances and receive free advice as well as receive up to £100 cashback if you decide to buy life insurance this way.
Other ways to avoid inheritance tax on your estate
Although life insurance written in trust can be arranged to fund the inheritance tax payable on your estate, there are many situations that could make this difficult including:
- You are too sick to qualify for life insurance
- Life insurance costs are outside of what you can afford
There are other simple steps that can be taken to reduce any inheritance tax liability. It is important to note that inheritance tax is not payable between married couples when the spouse leaves the estate to the other.
If you will be leaving assets that exceed the IHT threshold then it can be a simple case of arranging your assets differently. This FREE guide to Inheritance tax contains examples of how people have reduced their inheritance tax bill and instead passed the money on to their family. It is FREE inheritance tax advice that could save you thousands.
Further reading:
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