The Wire: Winter 2021Could your life insurance be making your Inheritance Tax problem worse not better

(Estimated read time 5 minutes)

Could your life insurance be making your Inheritance Tax problem worse not better

Have you taken steps to reduce your potential Inheritance Tax (IHT) bill?

If you have, new research shows that you’re actually in a minority of people. Almost three-quarters (74%) of UK adults have not taken any steps to reduce their IHT liability, a new study from AKG and Canada Life has revealed.

The study also found that just 1 in 5 people have taken any action to mitigate a potential IHT bill.

One method you can use to deal with a potential tax charge is to take out life insurance. While this won’t reduce the amount of IHT that may be due when you die, the payout from a policy can cover the tax bill, allowing you to leave the legacy you want to your beneficiaries.

While this is a popular method of dealing with an IHT liability, thousands of estates are paying IHT on the proceeds of these policies because of one simple omission. Read on to find out more.

Estates pay £280 million of unnecessary IHT

New HMRC data has revealed that more than 6,000 estates paid IHT on the payouts from life insurance policies in 2018/19 because they failed to place them in trust.

Of the 22,100 estates that paid IHT in 2018/19, HMRC figures show that more than a quarter of them (6,040) included life insurance policies. These policies were worth a total of £709 million, meaning that more than £280 million of IHT may have been paid on them. 

The payout from a life insurance policy will normally form part of your legal estate. And, if the life insurance proceeds take your estate above the IHT threshold, the portion of your estate above this will be liable to tax at the 40% rate.

However, if the policies were written into a trust, they would not normally form part of your estate and would therefore not be liable for IHT.

Experts speculate that part of the reason the figure is so high is that people buy life insurance without taking advice. Consequently, they are unaware that if they don’t write the policy in trust that it could form part of their estate, and that the proceeds may be taxed at 40%.

Setting up a trust is quick and easy

The easiest way to avoid IHT being charged on life insurance is to put your policy in trust. This is simply a legal arrangement that appoints trustees to look after the policy on behalf of your beneficiaries until such a time as the beneficiary is intended to benefit.

Setting up a trust is easy and typically won’t cost you anything extra. Your life insurance provider will be able to provide the necessary forms and it usually requires nothing more than a signature. While it’s generally better to set up a trust when you first buy insurance, you can put your policy in trust at any time.

Provided that you’re in good health when you put life insurance into trust, there are normally no IHT implications as, in most cases, the policy has no value.

Bear in mind that, if you are seriously ill when you put the policy in trust and die within seven years, HMRC could argue that the policy had a value when you put it into trust. In this case, they may include the value of the payout in your estate and levy IHT on the proceeds.

Two other reasons placing your life insurance in trust adds value

As well as ensuring IHT isn’t payable on the proceeds, there are two other good reasons to place life insurance in trust.

Firstly, it allows you to decide who your trustees are and, importantly, who will receive the proceeds of your life insurance policy. 

Setting up a trust can be particularly important if you’re not married or in a civil partnership as it will ensure your assets go to your intended beneficiaries.   

Secondly, writing your policy in trust also means the payout will reach your beneficiaries much quicker. This is because the payout will bypass probate.

Speak to an expert for help

According to official HMRC figures, the government collected £2.1 billion of IHT between April and July 2021, which is £500 million more than the same period last year.

Furthermore, the amount of IHT is set to rise yet further in the next few years, after the chancellor froze the threshold at which tax is payable at £325,000 until 2026. Rishi Sunak also froze the “residence nil-rate band” – an additional tax-free amount you can claim if you pass your home to a direct descendant – at £175,000 to the same year.

With this in mind, mitigating any liability you have can ensure you leave more of your estate to your loved ones. Putting your life insurance in trust is just one way to achieve this.

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