Life Insurance And Inheritance Tax: What's The Deal?

Life insurance is a monetary safety net for loved ones, with individuals paying regular instalments to an insurance company. In return, the insurance provider commits to paying out a lump sum to beneficiaries upon the policyholder's death. While most life insurance payouts are tax-free, inheritance tax may be due on the policy's proceeds when the policyholder dies. This is typically the case if the policy is not written in trust.

Inheritance tax on life insurance policies in the UK

In the UK, inheritance tax (IHT) is usually due on the value of an estate above a threshold of £325,000. This is levied at a rate of 40% and includes the proceeds of any life insurance. However, careful planning can help you legally sidestep IHT on your life insurance pay-out.

If the total value of your estate, including the pay-out from your life insurance policy, exceeds £325,000, then inheritance tax will be deducted from your insurance pay-out at a rate of 40%. For example, if your estate is worth £500,000, you will be charged inheritance tax on £175,000 (the amount over the threshold). 40% of that is £70,000, which is the amount owed in IHT.

You can avoid paying inheritance tax on your life insurance by writing your life insurance policy in trust. This means that the pay-out from your life insurance will not be included in the value of your estate for tax purposes. As a result, your beneficiaries will receive the full amount without any tax deductions. Additionally, putting your life insurance in trust can speed up the pay-out process as it won't be caught up in probate proceedings.

Putting your life insurance in trust gives you control over who receives the money and helps with estate planning. For example, you can specify that the payout goes to your grandchildren when they reach a certain age. This allows you to set aside the life insurance as an asset that will be managed by trustees until the intended beneficiary receives it.

While inheritance tax is typically charged on life insurance pay-outs that push the value of an estate above the threshold, careful planning can help you avoid this tax liability. By putting your life insurance policy in trust, you can ensure that the full amount goes to your chosen beneficiaries without being subject to IHT. This also offers the added benefits of faster access to funds and more control over how the money is distributed.

Life insurance and inheritance tax in the US

Life insurance is a monetary safety net for loved ones, with individuals paying regular instalments to an insurance company. In return, the insurance company commits to paying out a lump sum to beneficiaries upon the policyholder's death.

In the US, life insurance proceeds are generally not taxable. The beneficiary does not have to report the payout on their taxes. However, there are a few circumstances where the money is taxable.

When life insurance payouts are taxable

If the beneficiary receives interest, the interest is considered taxable income. While the lump-sum proceeds of the life insurance policy are typically not taxable, any interest earned is taxable, and funds that haven't been disbursed could accrue interest.

The payout may also be taxable if it is paid to the insured's estate instead of an individual or entity. If the money is paid to the insured's estate rather than a particular beneficiary, it could be subject to estate tax.

If the owner of the policy is not the same as the insured, the payout to the beneficiary could be considered a taxable gift.

How to avoid taxes on life insurance payouts

There are a few ways to avoid taxes on life insurance payouts:

• Transfer policy ownership: You can transfer ownership of the policy to another person or entity. However, note that any value beyond what was paid for the policy will be considered a taxable gift. Additionally, if you transfer the policy within three years of your death, the IRS will treat it as if it still belongs to you.
• Create an irrevocable life insurance trust (ILIT): You can transfer ownership of the policy from yourself to an ILIT, removing it from your estate. However, be aware that this type of trust cannot be revoked after it is set up.
• Be aware of gift tax limits: In 2024, the annual gift tax exemption is $18,000, and the lifetime exclusion amount is $13.61 million. If the policy's cash value does not exceed these limits, you may be able to avoid taxation.

Life insurance and inheritance tax planning

Life insurance can also be used as a tool for inheritance tax planning. Whole-of-life insurance cover can help reduce or eliminate the inheritance tax bill for your beneficiaries. To do this, the policy must be set up in trust, so the beneficiary can use the insurance proceeds to pay the inheritance tax bill.

How to avoid inheritance tax on life insurance

Life insurance is a financial product that provides financial support to your loved ones after your death. While the proceeds from a term, whole, or universal life insurance policy aren't usually considered taxable income for the beneficiary, there are some instances when inheritance tax may be applied. Here are some ways to avoid inheritance tax on life insurance:

Write Your Life Insurance Policy in Trust

Putting your life insurance policy in trust means transferring ownership of the policy to trustees, who become the legal owners and manage it on behalf of the beneficiaries. This arrangement allows you to control who gets the money and ensures a speedier payout by avoiding probate. It's important to set up the trust as early as possible, ideally when you first take out the policy.

Avoid Naming Your Estate as the Beneficiary

Naming your estate as the beneficiary of your life insurance policy can increase the estate's value and subject your heirs to higher estate taxes. Instead, consider naming a real person or entity, such as a spouse, child, or charity, as the beneficiary. This way, the proceeds are paid directly to them and are not included in your estate's value.

Create an Irrevocable Life Insurance Trust (ILIT)

By transferring ownership of your life insurance policy to an ILIT, you can remove it from your estate. This strategy ensures that the proceeds are not considered part of your taxable estate. However, keep in mind that an ILIT cannot be revoked once it's established, and you cannot be the trustee of the trust.

Be Mindful of the Three-Year Rule

According to the IRS's three-year rule, if you transfer ownership of your life insurance policy within three years of your death, the proceeds will still be included in your estate and taxed accordingly. Therefore, it's essential to plan ahead and make any ownership transfers well in advance of this three-year window.

Choose the Right Type of Life Insurance Policy

When using life insurance for estate planning, avoid term life insurance, as it usually expires by the age of 80. Instead, opt for a permanent life insurance policy, such as a guaranteed universal life insurance policy, which offers coverage until a much later age, such as 90, 100, or even 121.

When is life insurance taxable?

Life insurance payouts are generally not taxable, but there are certain circumstances in which they can be. Here are some of the instances in which life insurance proceeds may be subject to tax:

Inheritance Tax

Inheritance tax is a levy on the assets a person leaves behind when they pass away. In the UK, inheritance tax (IHT) is charged at a rate of 40% on the part of an estate that exceeds the threshold of £325,000. This includes the proceeds of any life insurance policies, which may therefore be subject to inheritance tax if the total value of the estate is above the threshold. However, if the policy is written in trust, life insurance payouts are usually exempt from IHT.

In the US, inheritance tax is only enforced in Iowa, Kentucky, Nebraska, New Jersey, Maryland, and Pennsylvania.

Estate Tax

An estate tax is a tax on the right to transfer property upon death. Life insurance proceeds may be subject to estate tax if the estate is worth more than the maximum threshold allowed. In the US, the threshold is $13.61 million for 2024.

Income Tax

Life insurance proceeds are generally not considered taxable income. However, if the owner of the policy and the insured person are not the same, the payout to the beneficiary may be considered taxable income. Additionally, if you sell your life insurance policy for a profit, this profit may be subject to income tax.

Generation-Skipping Tax

Similar to the estate tax, the generation-skipping tax is imposed on assets that skip a generation. This tax is only enforced when the value of the assets exceeds the same threshold as the estate tax.

Interest

Although the proceeds of a life insurance policy are typically not taxable, any interest earned on the proceeds is generally considered taxable income.

Life insurance and inheritance tax thresholds

Life insurance is a monetary safety net for loved ones, with individuals paying regular instalments to an insurance company. In return, the insurance provider commits to paying out a lump sum to beneficiaries upon the policyholder's death.

In the UK, most insurance policies, such as life insurance and critical illness cover, are generally excluded from the income tax regime. Policy premiums are not tax-deductible, and policy payouts are usually tax-free. This means that the funds received due to a claim are not subject to income tax. However, it's essential to consider the specifics of each policy as some types of insurance, such as investment-linked policies, have tax implications.

Inheritance Tax Thresholds

Inheritance tax (IHT) is a governmental levy on assets a person leaves behind when they pass away. The tax allows the government to claim a portion of the deceased's estate, including money and property, before transferring it to their heirs.

The IHT threshold is currently £325,000 in the UK. Anything above this threshold is subject to 40% inheritance tax, barring a many exceptions. Married couples and civil partners can combine their thresholds, effectively doubling the amount that can be passed on before IHT becomes payable. This is known as the 'nil-rate band'. Additionally, if you leave your home to your children or grandchildren, the threshold increases to £425,000.

Life Insurance and Inheritance Tax

Life insurance payouts are subject to inheritance tax if not written in trust. If the policy is written in trust, life insurance disbursements are usually exempt from IHT. This means the proceeds do not form part of the deceased's estate and are directed to specific beneficiaries of the trust.

If the policy is not written in trust, the estate's total value might be subject to IHT if it exceeds the threshold. Therefore, it is essential to structure your policy carefully to minimise or avoid IHT on life insurance.

Putting Life Insurance in Trust

Putting life insurance in trust is a simple way to keep it out of your estate. A trust is a legal arrangement that passes ownership of your policy to specific people you name (known as 'trustees'). As it's no longer legally yours, it can't be counted as part of your estate. This means your loved ones get the full, tax-free benefit of your policy.

Setting up a trust is usually straightforward, but there are legal and tax consequences, and it cannot be cancelled once done. Your life insurance provider will be able to help set up a trust, and it usually requires nothing more than a signature. Although it's generally better to set up a trust when you first buy cover, you can put your policy in trust at any time.

Frequently asked questions