How much is inheritance tax? Could taking out life insurance help to reduce it?

Credit: Liz Hunter, Commercial Director at MoneyExpert

Having life insurance gives you the comfort of knowing that your loved ones are covered financially should you pass away. This can help with everything from funeral costs and household bills to paying the mortgage or just helping to maintain their standard of living. 

But did you know that having it could also help reduce your inheritance tax bill? While there’s no specific tax on life insurance, either when you buy a policy or in the event of a valid claim, the value of your life insurance policy may be subject to Inheritance Tax if it forms part of your estate. 

However, if your policy is written in trust, then the payout from an insurance policy is kept outside of the estate. This means that in the event of your death, the policy proceeds can be received entirely by the beneficiaries of the trust who can then use it as they wish without it being subject to Inheritance Tax. 

Liz Hunter, Money Expert’s commercial director, provides her insights on everything you need to know about inheritance tax and how life insurance could potentially reduce your overall costs. Here’s everything you need to know below. 

What is Inheritance Tax? 

Inheritance tax is levied on the value of your estate after you die, and is currently 40% tax above the threshold of £325,000, which is called the nil rate band.

Your estate includes anything you own at the time of your death, such as your home, car, possessions, money, life insurance payouts and other assets. Therefore, if you had an estate worth £600,000, your heirs would have to pay £110,000 in inheritance tax from your estate. If they don’t pay this within six months, they’ll have to pay interest on what they owe.

If you’re married or in a civil partnership, you can transfer all of your estate and any unused nil rate band allowance to your partner upon your death. This allows you to combine your £325,000 threshold to double your nil rate band, meaning that your inheritance tax threshold will now be £650,000.

How does placing it in a trust help reduce your Inheritance Tax bill?

Placing life insurance in a trust can help reduce your Inheritance Tax bill by ensuring that the proceeds aren’t included when calculating the value of your estate. This is because the trust acts as a separate legal entity, and the policy proceeds, once paid into the trust, are held solely for the named beneficiaries. The trustees become the legal owners, not the policyholder. This can be anyone, whether they are friends or family, however, it is typically a family member who is named as the beneficiary. 

There are different types of trusts too, such as the Discretionary Survivor Trusts, which can offer more flexibility in how the proceeds are distributed. You can find out more on the government website. 

It’s important that if you’re considering placing assets in a trust that you seek advice from a professional financial adviser or solicitor, as they can sometimes increase tax liabilities if not set up correctly. They will ensure that your trust is set up currently and that it meets your specific needs and goals, including tax planning. 

Here are some other ways that you can legally avoid paying inheritance tax, or significantly reduce it, to increase the amount received by your loved ones in the event of your death:

Annual gift exemption

You can legally avoid inheritance tax with cash gifts prior to your death in England and Wales. Giving cash gifts to your loved ones before your death will reduce the overall value of your legal estate, thus reducing your inheritance tax liability.

You can give up to £3,000 each tax year to your loved ones without incurring inheritance tax. No tax has to be paid on gifts between spouses or civil partners, and there are additional types of cash gifts you can give tax-free depending on your relationship with the beneficiary. For example, a parent can give £5,000 to their child as a wedding gift without incurring inheritance tax, and a grandparent could give up to £2,500 to their grandchild for this purpose.

However, larger cash gifts could be liable for inheritance tax if they’re given within seven years of someone’s death. The amount of tax owed will vary depending on the value and when the gift was given. Cash gifts given between three and seven years before someone’s death will be taxed on a sliding scale from 40% to 0%. Cash gifts given in the three years before a death are taxed at 40%, decreasing to 0% as time passes up to seven years or more. Any gift given between three to seven years is taxed on a sliding scale known as ‘taper relief’.

Making a will

Making a will is important if you want to ensure that your assets are distributed in line with your wishes. It’s also important if you want to reduce the amount of inheritance tax paid. With a will, any taxes and debts are paid for by an executor before the remaining estate is distributed to friends, family or charities. Without a will, government legislation will control where your assets will be distributed and may be liable to inheritance tax that could have otherwise been avoided.

Downsize your property

Another common way to avoid inheritance tax is by downsizing your current property and distributing the money you make from the sale to whomever you wish prior to your death. Inheritance tax applies to assets you own at the time of your death, along with those given away within seven years. However, if you were to pass away within seven years of the cash gifts, you would pay inheritance tax on each gift, but it would be significantly less.

Donate to charity

You could try leaving a donation to charity in your will. If you gift enough to charity then you may be able to reduce the size of your estate enough to bring it below the inheritance tax threshold, and potentially pay no inheritance tax in the event of your death. Anything left to charity in your will will not only reduce your tax bill, but it also means that the money going to charity will be tax-free. This tax benefit was introduced to encourage more people to leave money to charity in their wills.

To qualify for the 4% reduction, the total amount left to charity must be at least 10% of what is known as the baseline amount. The baseline amount is calculated by taking the value of the estate chargeable to inheritance tax after deducting liabilities, exemptions, and the available nil-rate band, but before deducting the amount donated to charity.

There are two ways you can do this - either leave specific instructions and specify the charity in your will, or leave it up to the trustees of your will. For simplicity, if you want to make things easier for those managing your estate, then it would be worth outlining your wishes, and the charity you’d like to leave money to, clearly in your will. Remember, in order for this to be valid, it needs to be formally witnessed and signed.

Top up your pension

You can pass on any money saved in your pension free from inheritance tax through a beneficiary nomination form in your will. This is ideal if you have other sources of income, like a part-time job, and don’t need to live on your pension in retirement, so are able to leave your pension pot intact.

You can also contribute to a family member’s pension. The recipient would maintain their pension allowance of 100% of their earnings, or £3,600 if they have no earnings. This means that as long as their pension contribution remains below this allowance, you can donate as much as you like. The pension holder can then claim a 20% tax rebate and could possibly claim the rest through a self-assessment tax return. 

Place other assets within a trust

Finally, another way to reduce exposure to inheritance tax is by placing your assets in a trust, as your estate will not include these assets, therefore avoiding inheritance tax on this amount. Trusts are perfect for leaving a gift in your estate with somebody who is too young to handle their affairs. An ‘interest in possession’ trust is another option which allows you to take income from these assets whilst avoiding inheritance tax. It’s important that if you’re considering placing assets in a trust that you seek professional advice, as they can sometimes increase tax liabilities if set up incorrectly.