People in Britain are increasingly liable to be caught in the inheritance tax net, thanks largely to the rising property prices of recent decades.
Under current rules, the first £325,000 of a person’s estate is free of the tax, but any assets above this level are charged at 40%.
The government has taken some steps to mitigate the impact of inheritance tax: married couples and civil partners can now pool their allowances to create a combined tax-free allowance of £650,000 (assets passed from one spouse to another are free of inheritance tax).
And by 2020, parents and grandparents will be able to leave property worth up to £1 million to their children or grandchildren without any tax being due (couples will each be given a £500,000 allowance which can be combined).
Nevertheless, inheritance tax is likely to remain an important issue – and life insurance is one way of dealing with any potential bills.
Read Paul Lewis' guide to understanding inheritance tax.
How insurance can help
Life cover is often taken out to protect families or partners in the event of the main breadwinner’s death. But many older people sign up for life insurance so that their relatives have enough money to pay any inheritance tax bills that may be liable upon their death. This can make the difference between being able to keep a family home and having to sell it to cover the tax bill, for example.
Normally, this would be done with a whole-of-life insurance policy, which remains in force until the policyholder’s death, provided their premiums are fully paid.
With term insurance, which only runs for a fixed period of time – until a mortgage is paid off, or until children have left home, say – there is a good chance that the policy will end before the policyholder dies. In this case it would not be able to offset any inheritance tax liability.
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Levels of cover
When you take out life insurance, you can decide how much the policy will pay out upon your death.
If you are signing up for cover to mitigate inheritance tax, you will have to estimate the potential size of your bill. This can be difficult as you don’t know a) when you’ll die, b) what the value of your assets will be at this point and c) whether the government’s current inheritance tax policy is likely to change.
Using a Trust
Under normal circumstances, any payment from a life insurance policy could itself be subject to inheritance tax. However, by writing the policy in Trust, the tax should be avoided. What’s more, the payout will not have to go through the often lengthy probate process, so your relatives will get their money much more quickly.
Trusts can be simple to set up, but it is well worth seeking expert legal advice before doing so to ensure this approach is appropriate to your circumstances.