IHT Treatment of Life Insurance, Death in Service and Pensions

Generally, inheritance tax (IHT) is a tax charged on a person’s estate on death. Your estate is everything that you leave for your beneficiaries to inherit. For many people this will include your savings, investments, your home, and any personal possessions, minus your debts. It can also include life insurance policies and death in service benefits.

When a person takes out a policy of life assurance in their name, the benefit of that policy belongs to them. This means that on the person’s death, when the policy matures, the insurance company will pay the proceeds to the personal representatives of the deceased, for them to distribute amongst the beneficiaries according to the will or rules of intestacy. However, because it is in the name of the deceased it amounts to a portion of their estate and therefore inheritance tax may be payable.

However, an alternative option is to take out a life assurance policy and have it written into trust for the benefit of specified individuals. A policy may also be transferred or assigned to named beneficiaries, and this can occur when the policy is first taken out or at a later date.

Protecting your assets from IHT

Once a policy has been written into trust, it means that the benefit of that policy no longer belongs to that person and does not, therefore, form part of their estate on death. In practical terms this would mean that when the person dies, the proceeds will be paid by the insurance company to the named beneficiaries irrespective of the deceased’s will or the rules of intestacy. In many cases this could result in a saving to the estate’s inheritance tax burden, as the value of that policy would not be included in the value of a person’s estate when calculating any tax that may be due.

Furthermore, on the topic of trusts, they also remain an excellent tool to use for death in service benefits. A death in service benefit is a form of life insurance provided by an employer which is often linked to a company pension. For most people it will have a value of a multiple of your salary in the region of 2 – 4 times. Upon the death of the employee, and providing it is held in trust, the sum due will be paid by the trustees of the pension to members of the deceased’s family or dependants.

However, the beneficiaries are chosen at the trustees’ discretion. Once again, the major benefit of putting a death benefit scheme into trust is that it will usually avoid inheritance tax as they do not form part of your estate.

Are there any exceptions?

It is important to remember there are some exceptions. For example, if the insurance policy is for a particularly large sum assured, more than the Nil Rate Band, which is currently £325,000, the trust itself will be subject to inheritance tax for any sum above that figure. It is therefore important to ensure that any life insurance that exceeds £325,000 is made up of more than one policy, in separate trusts made on separate days. This will prevent the trusts being treated as one. Similarly, any large death in service benefits above £325,000 will also become subject to inheritance tax unless steps are taken to mitigate this.

Pensions and IHT

Finally, a point to consider is the contributions a person makes to their pension in their lifetime. Usually, contributions to a pension scheme are not considered lifetime transfers for the purposes of inheritance tax and will be excluded from a person’s estate. However, if the contributions are made when a person is in ill health, then they may be considered a transfer for value. Although it is usually accepted practice that contributions made two years prior to death are not transfers for value that could be subject to inheritance tax.

In addition, a contribution made to someone else’s pension would also be considered a lifetime transfer as the benefit will be for another person, although depending on the surrounding circumstances, these transfers may be exempt or potentially exempt. It is, therefore, always worth consulting a legal and financial professional when you are considering the use of any trusts or changes to your pensions.

To conclude, where life insurance policies and death in service benefits are not written into trust, this can have a major impact on an individual’s estate at the time of their passing, as any inheritance tax liability can greatly diminish the size of the assets left to your beneficiaries.

Many people who take out life insurance policies or who arrange death in service benefits with their employer do so in order to protect their family in the event of their death. With this in mind, it is worth considering going a step further and seeking legal advice to make sure the full benefits of those policies and schemes can be utilised by your chosen beneficiaries in the event of your passing.

Frequently Asked Questions

What is inheritance tax (IHT)?

Inheritance tax is a tax charged on the value of a person’s estate when they pass away. This includes assets such as property, savings, investments, and certain insurance benefits, after deducting any debts.

Does life insurance form part of my estate for IHT purposes?

Yes, if a life insurance policy is held in your name, the proceeds are typically included in your estate and may be subject to inheritance tax.

How can I prevent life insurance from being taxed under IHT?

You can place your life insurance policy into a trust. This means the policy is no longer part of your estate, and the payout goes directly to your chosen beneficiaries, usually free from IHT.

What is a death in service benefit, and is it subject to IHT?

A death in service benefit is an employer-provided life cover, usually based on a multiple of your salary. If held in trust (as is common), it typically does not form part of your estate and is not subject to IHT.

Are there limits to how much can be placed into trust without triggering tax?

Yes, if the value of a policy placed in trust exceeds the Nil Rate Band (currently £325,000), there may be inheritance tax implications on the excess amount.

Example

Life insurance written in Trust

Sarah takes out a £30,000 life insurance policy and places it into a trust for her children. When she dies, the policy pays out directly to them and does not form part of her estate, meaning no inheritance tax is due on that amount.