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Is Life Insurance Subject to Inheritance Tax?

Posted on the 28 October 2013 by Gbmc @gladstonebrooke

Does your life insurance money get taxed?

When your family cashes-in your life insurance policy, will they have to pay inheritance tax? The answer to that question depends on a number of factors.

What is inheritance tax?

When you die, what you leave behind is known as your estate. Put very simply, your estate is all of your ‘stuff’. It includes your money, property, possessions and yes, your life insurance money.

If the total value of the estate (everything you leave behind, minus any debts) is under £325,000 it will not be subject to inheritance tax. However anything over the £325,000 threshold will be taxed at the rate of 40%. This limit, known as the “nil-rate band”, was set in 2009 and has been frozen until at least 2017 – meaning that as the cost of living rises the inheritance tax limit will effectively be lowered.

Your spouse doesn’t pay inheritance tax

If you die and leave all your assets to your spouse or civil partner, they will not have to pay inheritance tax. When they die, your tax-free allowance will be added to theirs, meaning that your children will only pay inheritance tax on anything over £650,000.

Why do we have to pay it?

Also dubbed as “death duty” or the “death tax”, inheritance tax is a controversial and unpopular tax. Some argue that the money was taxed when it was earned, and that it’s unfair to tax people twice. But like it or not, inheritance tax is here and it’s not going away any time soon.

The history behind it goes back to the French Revolution. The idea was to interrupt the chain of inherited wealth – the children of the rich becoming richer and the children of the poor staying poor. By taxing the estate of a wealthy deceased person, some of their money could be redistributed and used to benefit the rest of society.

The problem nowadays is that it’s not just the very wealthy that are affected by inheritance tax. Thanks to steadily rising house prices, many ‘average’ people find themselves caught out by the £325,000 threshold.

It may sound like a lot of money to many people, but bear in mind that the average house value in the UK is now just over £240,000. If you exclude London and the South-east it’s still around £150,000 (source). Add to that a few thousand pounds in savings, a car  and your life insurance money, and you see how quickly everything adds up.

Can it be avoided?

Very affluent people usually have accountants or financial planners who can help them minimise the amount of inheritance tax they will have to pay. It’s the people on a modest income who are just over the threshold who tend to be hit the hardest.

If you think you are one of these people, there are a few perfectly legal and legitimate ways to reduce the amount of inheritance tax you pay.

Give part of your estate to charity

If you donate some of your estate to charity, the donation will not be taxed. If you give at least 10% of your estate to charity, then the remainder of your estate (above £325,000) will only be taxed at 36%. This won’t leave you with more money, but at least less will go to the taxman and more will go to a good cause.

Give gifts

The rules say that if you give away part of estate to another person as a gift, it will no longer be counted as part of your estate and won’t be taxed – as long it was given away more than seven years before your death. If you give away a gift but you die within seven years, the gift will still be counted as part of your estate and will still be subject to tax. However there are a few exemptions:

  • The first £3,000 you give away in a year is ignored and will not be taxed (regardless of the seven year rule). If you don’t manage to give away £3,000 in one year, it can be carried over to the next year (but not the year after).
  • The first £250 you give to any one individual in one year is also ignored and won’t be taxed.
  • You can give away part of your income as a regular payment to another person (the key word here being “regular”). It won’t be taxed as long as A the payments aren’t eroding your capital and B the payments don’t reduce your standard of living. Remember inheritance tax is a tax on your assets, not your income.

Put your life insurance money into a trust

This is by far the easiest, simplest method of minimising inheritance tax, but surprisingly few people do it.

It’s not uncommon for people to insure their life for £100,000 or more. If this money is simply left to a beneficiary (such as your partner or children) it will count towards your estate and could be subject to inheritance tax. To get around this, you can have your life insurance written-in-trust. In essence this ‘removes’ the money from you and puts it into a trust fund – which is not counted as part of your estate. You can then name trustees to manage the trust after your death.

One huge benefit of doing this is that your family can access the money pretty-much immediately. Normally they would have to go through the time-consuming probate process before being able to access any funds.

For more information on written-in-trust life insurance, visit our life insurance page and arrange to speak to a Money Club advisor*.

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