Life insurance and inheritance tax

When you die, your ‘estate’ (your property, your money and anything else you own as an ‘asset’) is added up and valued. If it totals more than the £325,000 inheritance tax  threshold (or £500,000 if the estate includes a residential property that is left to direct descendants), anything above that amount may be subject to inheritance tax – which is currently 40%. This could mean your beneficiaries receive considerably less financially, than you originally expected. It's worth bearing in mind that tax rules may change over time and tax liability depends on personal circumstances. You may want to talk to a financial adviser for further information. If you don't have a financial adviser, you can find one at unbiased.co.uk. Please be aware that you may need to pay for this advice.

The life insurance payout can be counted as part of your 'estate' after you're gone. If this is the case and it pushes the total value of your estate over the inheritance tax threshold, the excess could be subject to inheritance tax at 40%.

It's worth mentioning here that for married couples and people in civil partnerships, the surviving spouse may be able to combine their £325,000 thresholds, effectively doubling  what's called the 'nil-rate band'. This then means there's no inheritance to pay on estates valued up to £650,000.  This may increase to £1,000,000 if you give your main home to descendants, such as children or grandchildren, including adopted, foster or stepchildren.

So how is it possible to ensure that any life insurance payout doesn't fall within the scope of inheritance tax? Thankfully, it's within your power to do something about it, with just a little savvy financial planning. Specifically, by putting your life insurance in trust.

Putting your life insurance in trust is a simple way to keep it out of your estate.

In short, a trust is a legal arrangement that passes ownership of your policy to specific people you name (known as ‘trustees’). As it’s no longer legally yours it can’t be counted as part of your estate. This means your loved ones get the full, tax-free benefit of your policy.

While setting up a trust is usually pretty straightforward, there are a few things to be aware of before pushing the button. It’s a good idea to make sure you’re happy with everything, so do your research and maybe talk to a solicitor or financial adviser too. If you don't have a financial adviser, you can find one at unbiased.co.uk. Please be aware that you may need to pay for this advice. There are legal and tax consequences to setting up a trust and, once it's done, you can't simply change your mind and cancel it. Find out how Aviva trusts work.

Yes. A whole of life insurance policy - sometimes known as life assurance - pays out when you die. This is different to the type of life insurance that pays out if you die during a specific period. With a whole of life policy, you can use the proceeds to pay off some - if not all - of a future inheritance tax bill.

To make sure you’re getting the cover you need, it might be worth speaking to a financial adviser.