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Understanding inheritance tax and life insurance

Jenni Hill
Last Updated 1 July 2024

When you pass away, the value of any savings, investments, assets and material possessions will be added together to form your estate. If you have a life insurance policy, the payout may be added to your estate too, but does this mean you’ll need to pay inheritance tax on it? Let’s take a look at how inheritance tax and life insurance work.

In this guide

Is life insurance part of inheritance?

Yes, life insurance can form part of a person’s inheritance. When you pass away with a life insurance policy in place, the payout may be added to the rest of your estate for inheritance tax purposes. 

However, 96% of people won’t pay any inheritance tax at all, thanks to a number of legal ways to reduce your taxable estate along with two tax-free allowances known as the nil-rate band and the residence nil-rate band.

💷 No inheritance tax due on first £325,000 of a person’s estate (nil-rate band)

If the total value of your estate is below £325,000, your beneficiaries will receive the life insurance payout without paying any tax at all. If your estate is worth more than £325,000, anything above this threshold will be taxed at 40% - unless you’re able to take advantage of other allowances.

If you’re married or in a civil partnership, you and your spouse/partner can combine your £325,000 nil-rate bands and effectively double your tax-free allowance. This would let you pass on up to £650,000 without paying inheritance tax.

🏠 Leave your home to your children or grandchildren and benefit from an additional £175,000 IHT free (residence nil-rate band)

There’s also the residence nil-rate band, which lets you pass your main home onto your children or grandchildren without paying inheritance tax on the first £175,000 - as long as it’s worth less than £2 million. If it’s worth more than £2 million, your residence nil-rate band will decrease by £1 for every £2 above £2 million that the estate is worth. If you’re married or in a civil partnership, you can combine your nil-rate bands and residence nil-rate bands to pass on up to £1 million tax-free.
Learn more: The benefits of an early inheritance for first-time buyers

How to protect life insurance from inheritance tax

If you’re passing on a large estate, you can protect your life insurance payout from inheritance tax by placing it in a trust. The payout will no longer form part of your estate and your beneficiaries will receive the full payout. To set up a trust, you’ll need to choose a person or multiple people to act as a ‘trustee’. They’ll become the legal owners of the life insurance policy along with any other assets that you place in the trust. It’ll be their responsibility to take care of the assets within the trust until it’s time to pass them onto your beneficiaries. 

It’s unlikely that you’ll be able to make any changes to your life insurance policy once it’s been placed in a trust, so it’s a good idea to speak to a financial adviser before making a decision. 

Does life insurance go towards inheritance tax?

Yes, you can use a life insurance payout to cover the inheritance tax bill. By placing the life insurance policy in a trust, you can protect it from inheritance tax and use it to pay off any IHT due on the rest of your estate. This can be particularly helpful if you don’t want your beneficiaries to have to sell properties, antiques or sentimental assets to pay the tax bill. 
Learn more: Do beneficiaries pay tax on life insurance?

How do I pick the right policy for me?

Choosing the right life insurance can be overwhelming. Get a quote from our team of insurance specialists today and we’ll compare life insurance policies from a choice of insurers until we find the right one for you.

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Is a joint life insurance policy subject to inheritance tax?

Yes, a joint life insurance policy can be subject to inheritance tax if it forms part of an estate that exceeds the nil-rate band and residence nil-rate band. 

Learn more: Can I have more than one life insurance policy?

Is life insurance a way to leave an inheritance?

Yes, life insurance can be a way to leave an inheritance. You could provide your family with a financial safety net which can be used to cover funeral costs, pay off debts, or cover living expenses for a period of time. Some people take out much larger policies so their loved ones can use the money to travel, take an extended period off work, or even buy their first homes. 

The larger the payout, the higher your monthly premiums will typically be, so before committing to a particular policy, consider whether you’ll be able to afford the payments for the rest of the policy term.

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