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Your Questions: All about Tax<br>and LIFE INSURANCE

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The proceeds of life insurance, whether they are given out in a single lump sum or on a monthly basis, are tax-free.

However, there is an exception to this. Life insurance can not be taxed, but your estate can. The proceeds of the life insurance form part of your legal estate which can become subject to inheritance tax (IHT). How does this happen and how can you avoid paying IHT?

How does the Inheritance Tax affect Life Insurance?

In the UK, the inheritance tax is due on estates worth more than £325,000. This may seem like a lot but it is worth noting the rising house prices, especially in the South-east. As of March 2020, the average house price in the UK is £231,855, and this figure is rising.

The proceeds of life insurance are part of that person’s estate. So if the total value of your estate exceeds £325,000, then your life insurance will be liable for the tax. Even if you are not liable, the proceeds of the life insurance could push you over the limit.

No matter what the income of your dependents is, if you push this threshold then the extra money will be taxed at a levy of 40%.

How can I avoid the Inheritance Tax?

There is a straightforward step you can take to avoid life insurance inheritance tax and that is — setting up your policy in trust. A trust allows you to set aside your policy to benefit a specific person (or people). It will be managed by a trustee (or trustees) who will then look after it on behalf of your dependents until an arranged time.

Unlike regular life insurance, this is not restricted to the time you pass away. This means you get greater control over the timing of your life insurance, as it does not have to be given as soon as you die.

For example, married couples or people in a civil partnership could choose their spouse/civil partner to be the trustee on behalf of their children. Your spouse would then look after the policy until the children are old enough to look after the proceeds themselves.

Another benefit to putting your life insurance policy in a trust is that the money will probably be paid out quicker than regular life insurance. This is because the policy will be free from the legal tangles that can often come from the processing of an estate after death.

It is fairly simple to set up a trust at any time and can probably be done free of charge. It is best to have a conversation with your insurer before you decide, as in some cases you may be liable for higher income tax. This is a complicated issue but your insurer will be able to walk you through it so you can come to the best decision for you.

Why does writing a Life Insurance Policy in trust work?

When your policy is written in trust, you do not technically own it anymore – at least in the eyes of the law. It is now under the ownership of your trustees, which means it is not part of your estate either.

This is why it is processed separately from the rest of your assets and your estate. It is not technically your property and so will not be taxed like it is, even if you breach the inheritance tax threshold.

Can I change my mind afterward?

Once you have written your policy in trust and handed it over to the trustees, it is no longer yours to control. This is called an “irrevocable act,” and can not be taken back.

This is why it is important to make sure you go over what you want to be in your life insurance policy until you’re completely happy with it.

If you have decided to write your life insurance in trust, you may now be wondering which type of life insurance suits you best.

What type of Life Insurance should I get?

It can be daunting to pick which life insurance is best for you, especially when faced with so many options. We’ll break down the most popular options to make your choice easier.

The first thing to decide is how long you want the insurance to last. If you want life insurance for a limited amount of time, for example, 20 years, then term insurance is the best match for you. This is the most common type of insurance.

Term insurance will pay out a lump sum if you die within the term. If you pass away within the term then your loved ones will receive a pay-out. If you live beyond the end of the term then the policy will simply come to an end. People will take out term insurance to pay off a mortgage or to make sure their young children will be provided for until they come of age.

There are several different types of term insurance. First, let’s look at three main types of plans you can get:

Renewable – This plan allows you to renew your term insurance policy when it expires. This is useful as you will not need to go through another health check. Be aware that the money you pay (also known as premiums) can change.

Reviewable – With reviewable policies, your plan will be fixed for a set period. After this period ends your insurer can review it and your changed circumstances. The premiums may be changed.

Convertible – Convertible life insurance is where you start out on term insurance but with the option of switching to whole-of-life insurance later on down the line if your circumstances change.

Also important to consider is what type of pay-out you want your beneficiaries to get. Do you want:

A sum that shrinks as your debt is paid off –If you want the pay-out and the premiums you pay into your policy to decrease as you advance into the term, then decreasing term life insurance is the policy to go for. Many people choose this plan to sync with the repayments on their mortgage or any other debt.

A sum that grows alongside the cost of living –Some people choose to have their pay-out and premiums rise as the term advances and this is called increasing term life insurance. This is so the pay-out will maintain its value later on down the line, despite inflation.

A fixed sum –You might want your loved ones to have security and know exactly the amount of pay-out they will receive. This is where level term life insurance is the most appropriate option. The amount will stay the same throughout the years and payout the sum agreed if you pass away during the policy term.

There are also other options for arranging the pay-out, for example, a policy where your family will receive the money as a regular monthly income. This particular policy is called Family income benefit. It is worth having a look at all the policies available, as well as the main ones if you are not sure exactly what is right for you. This way you can ensure you get the plan that fits your priorities the most.

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