The answer is complicated. In some cases, the life insurance policy is considered part of the legal estate. Any portion of an estate above the £325,000 inheritance tax threshold will be subject to the 40% inheritance tax, including a life insurance pay-out.
The best way to avoid inheritance tax being levied on a life insurance pay-out is to put the policy in trust. This means that the life insurance provider becomes a trustee of the asset, holding the legal title to it, and, in the event of the policyholder’s death, has an obligation to pay out the sum insured to the beneficiaries specified in the trust deed.
That means the pay-out is never considered in the possession of the deceased, and thus can’t be part of their estate or subject to inheritance tax. Instead, the money goes directly to the beneficiaries of the insurance policy.
Additionally, because the life insurance policy isn’t considered part of the estate, the beneficiary doesn’t have to wait for the probate process to be complete to access it. Instead, the life insurance company can issue the pay-out immediately upon the production of a death certificate.