Inheritance tax warning as thousands of households overpay £327m 'unnecessarily'

Nearly 7,000 families paid inheritance tax on life insurance policies according to HMRC figures released this week, but many would have escaped a bill if their policy was written into trust.

Of the 27,800 estates that paid inheritance tax in 2021/22, nearly a quarter of them (6,810) included life insurance policies.

These life insurance policies were worth a total of £819million, meaning up to £327million of inheritance tax may have been paid on them.

However, if the policies were written into trust, they would not normally form part of the deceased’s estate and would therefore not be liable for inheritance tax.

Sean McCann, Chartered Financial Planner at NFU Mutual, explained: “Many people buy life insurance without advice, so aren’t aware that if they don’t put the policy in trust it’s included in their estate and could end up being taxed at 40 per cent.

“Putting life insurance policies into trust is relatively straightforward. If you have life insurance and it isn’t in trust, phone your provider and ask for a trust form.

“Provided you’re in good health when you put it into trust, there are normally no inheritance tax implications, as in most cases the policy has no value.

“However, if you are seriously ill when you put the policy in trust and die within seven years, HMRC could argue that the policy had a value when you put it into trust and seek to include that value in your estate and charge inheritance tax.

“Using a trust can also mean a speedier payout in the event of a claim, as the family won’t need to wait for probate, which can make a huge difference to dependants relying on the money to cover day-to-day bills.”

HMRC collected £7.1billion of inheritance tax in 2022/23, a £2billion increase from £5.1billion three years previously.

McCann added: “The tax-free allowances are frozen until 2028, meaning more and more families will be caught in the net.

“This makes it all the more important that families don’t pay inheritance tax on life insurance policies unnecessarily.”

Those who take out a life insurance policy will pay premiums for the rest of their life but when they die, the policy will pay out enough to cover their tax bill.

This could be a great stress relief to know one's family won't be left scrabbling to pay the taxman.

A life insurance policy is written in trust and is paid out to named trustees. It will remain outside of one's estate and no inheritance tax will be payable on the value of the policy on their death.

The other advantage of placing the insurance policy in trust is – as the trust deed gives one's trustees the power to administer the policy – it can be paid out immediately upon their death without needing probate to be granted.

This means trustees can then settle the inheritance tax bill without a wait.