Will My Family Have To Pay Tax On My Life Insurance Payout After I Die?
Usually, life insurance payouts - either lump sums or regular income payments - are not taxable. This means that your family will not have to pay either Income Tax or Capital Gain Tax (CGT) on the money. However, the payout will form part of your estate for Inheritance Tax (IHT) purposes. The entire pot of what you leave may be subject to IHT if it totals up to more than £325,000. If you have a property to sell then it is quite easy to exceed this figure with the house alone. That's before you add on anything else.
Avoiding tax payments on life insurance payouts should form part of your overall estate planning. IHT is levied at a rate of 40% on anything over the £325,000 threshold.
What will my estate include?
Your estate will include your house, the value of your possessions – cars, jewellery, high-value consumables and second properties. It also covers any financial increments such as savings accounts or life insurance payouts. For many people, the £325,000 margin is taken up solely by the value of their home. However, recent changes in the rules mean that if you leave your home to your children or grandchildren, then this threshold increases to £425,000. With a reasonably sized property, it is easy for life insurance payouts to become subject to IHT which bites at 40%.
How to avoid IHT on a life insurance policy?
Many people put their life insurance policy in trust to avoid IHT. This is quite legitimate and is not illegal. The policy is placed in the hands of trustees who look after it for your named beneficiaries. Because you no longer 'own' it, the policy and any payout will not form part of your estate. It is therefore not subject to Inheritance tax
Because the benefit of the plan is designed wholly for other people, it doesn't actually matter who owns the policy. Most people are only concerned that their loved ones receive the money when they die.
How can you set up a trust?
This is not as complicated as it sounds. Most insurers offer this routinely when the policy is taken out. It doesn't usually cost anything extra. If you already have a policy and it is not yet in trust then you can do this at any time.
The trust will allow you to specify who receives the money. This is not something the Trustees can interfere with or alter after you die. The nominated individuals are called 'the beneficiaries'.
Are there any other advantages to putting a life insurance policy in trust?
There is one key advantage and that is that the payout is usually available more quickly than if the plan formed part of your estate. When someone dies, all their financial arrangements are effectively frozen for some time. This can make it difficult for relatives who may be waiting for weeks if not months to receive monies from your estate. A life insurance policy will bypass probate and can pay out reasonably quickly. All the insurance company will need is a death certificate to prove that you have died. This is something that is relatively easy to set up and can be done even in the event that you find out you are going to die.
Pitfalls to watch out for
In order to avoid any income tax liability, the insurance policy must fall within a category described as 'non-qualifying'. This means, in simple terms, that it is straight life cover - there is no investment element included as well. A policy which does not fall within the non-qualifying classification might result in a beneficiary being liable for income tax.
Your beneficiaries will probably not be liable for any income tax on a lump sum received but they may be liable to pay tax on any interest received.
The most common type of life insurance policy is referred to as 'term insurance'. This will pay out a specified sum if you die within the term of the plan. Term insurance will usually be a 'qualifying policy'. Term insurance policies can be level or increase over the term. This is to reflect inflation and ensure that there is a real value at the end of a long term, say twenty years. There are other variations on this theme and also something called family income benefit. This does not pay out a lump sum to beneficiaries or dependents but instead makes regular payments in the event of your death.
Policies do vary in what the cover includes so always drill down into the detail before you buy. Look carefully at any tax implications before you purchase a life policy and seek advice from an independent specialist if you are unsure.
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