Inheritance tax is a charge on the estate of a person who has died. For many families, particularly those who own property in the UK, the liability can run to tens or hundreds of thousands of pounds. Life insurance, structured correctly and written in trust, is one of the most established and practical tools available for covering this liability and ensuring that your beneficiaries receive the full value of what you intended to leave them.
Understanding the Inheritance Tax Threshold
Inheritance tax in the UK is charged at 40% on the value of an estate that exceeds the nil rate band. The standard nil rate band is currently 325,000. This threshold has been frozen and is not expected to change in the near term, meaning that more estates are drawn into the inheritance tax net each year as property values rise.
In addition to the standard nil rate band, there is the residence nil rate band (RNRB), currently set at 175,000. This additional allowance applies where a main residence is passed on death to direct descendants such as children or grandchildren. Together, these allowances mean that a single individual can potentially pass up to 500,000 free of inheritance tax, and a married couple or civil partners can potentially combine their allowances to shelter up to 1,000,000.
Assets passing between spouses and civil partners are generally exempt from inheritance tax regardless of value. The inheritance tax liability therefore typically crystallises on the death of the surviving spouse or civil partner, when the estate passes to the next generation.
How a Whole of Life Policy Written in Trust Can Cover the Liability
A whole of life insurance policy does not have a fixed term. It provides cover for the policyholder’s entire life, paying out a lump sum on death whenever that occurs. This makes it the appropriate vehicle for inheritance tax planning, where the liability arises at an unknown future date rather than within a defined term.
The key step is writing the policy in trust. A whole of life policy that is not written in trust forms part of the deceased’s estate on death. Not only does this mean the payout could itself attract inheritance tax, but it also does not solve the problem it was intended to address. By placing the policy in trust, the sum assured sits outside the estate. On the death of the last survivor, the trustees can access the funds immediately, without waiting for probate, and use them to meet the inheritance tax bill. The estate itself passes to the beneficiaries without being depleted by the tax liability.
For married couples and civil partners, a last-survivor whole of life policy written in trust is the standard structure used for this purpose. The policy pays out on the death of the surviving spouse or civil partner, at exactly the point when the inheritance tax liability becomes due.
Premiums as Normal Expenditure Out of Income
One important consideration in inheritance tax planning using life insurance is the tax treatment of the premiums themselves. If you pay the premiums from your estate, those payments could theoretically be treated as part of your estate for inheritance tax purposes over time.
However, HMRC’s inheritance tax rules include an exemption known as normal expenditure out of income. Under this exemption, gifts or payments that are made out of regular surplus income, that form part of a habitual pattern, and that do not reduce the donor’s standard of living are exempt from inheritance tax immediately, without the seven-year gifting clock applying. Regular life insurance premiums paid from income can qualify for this exemption, provided the conditions are met.
This makes whole of life premiums for inheritance tax planning particularly tax-efficient when funded from income. HMRC provides detailed guidance on the normal expenditure out of income exemption, and it is important to keep contemporaneous records of income and expenditure to support any future claim for this exemption.
Interaction with Gifting Rules
Inheritance tax planning often involves a combination of strategies, of which life insurance is one element. Gifting assets during your lifetime is another common approach. Gifts made more than seven years before death are generally exempt from inheritance tax. Gifts made within seven years may attract taper relief, reducing the tax due depending on how many years before death the gift was made.
Life insurance can complement a gifting strategy. Where large gifts have been made and the donor dies within seven years, a term assurance policy covering the potential inheritance tax liability during that seven-year window is a recognised planning tool. This is often referred to as gift inter vivos cover.
Professional Advice Is Essential
Inheritance tax planning involves a complex interaction of rules, allowances, exemptions, and personal circumstances. Life insurance is one tool within a broader planning strategy, and it is important that it is structured correctly to achieve the intended outcome. A whole of life policy that is written in trust but with the wrong trust structure, or funded in a way that does not qualify for the normal expenditure out of income exemption, may not achieve what was intended.
Seeking advice from a qualified financial adviser who specialises in estate planning, alongside a solicitor experienced in trust law, is strongly recommended before implementing an inheritance tax planning strategy. You can explore whole of life and other life insurance options at TopQuote as a starting point for understanding what products are available.
Frequently Asked Questions
What is the inheritance tax rate in the UK?
Inheritance tax is charged at 40% on the value of an estate that exceeds the available nil rate band allowances. The standard nil rate band is 325,000 per person. A reduced rate of 36% applies where at least 10% of the net estate is left to a qualifying charity. Assets passing between spouses and civil partners are exempt from inheritance tax on the first death.
Does life insurance form part of my estate for inheritance tax?
A life insurance policy that is not written in trust does form part of your estate on death and could be subject to inheritance tax. Writing the policy in trust removes it from your estate entirely, meaning the payout is not included in the estate valuation and is not subject to inheritance tax on the proceeds themselves.
What is the normal expenditure out of income exemption?
This is an inheritance tax exemption that allows regular gifts or payments made out of surplus income to be exempt from inheritance tax immediately, provided the payments are habitual, made from income (not capital), and do not reduce the donor’s standard of living. Life insurance premiums paid regularly from income can potentially qualify for this exemption, making them immediately outside the estate for inheritance tax purposes.
What is a last-survivor life insurance policy?
A last-survivor policy, also known as a joint life second death policy, insures two lives and pays out on the death of the second insured person. This structure is used in inheritance tax planning for couples because it aligns the payout with the point at which the inheritance tax liability actually arises, which is on the death of the surviving spouse or civil partner.
Sources
About the Author
Tanweer Hussain is the editor at TopQuote.co.uk. He oversees the editorial accuracy of all published content, with a particular focus on the factual detail relevant to UK protection insurance. TopQuote is authorised and regulated by the Financial Conduct Authority.
This article is intended for general information purposes only and does not constitute financial advice. Your individual circumstances will affect which options may be available to you. TopQuote.co.uk is a comparison and information service, not a financial adviser. Always seek independent financial advice from a regulated adviser before making any financial decisions.