What is Inheritance Tax and How Can Life Insurance Help?

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What is inheritance tax (IHT)?

How much is it? (examples)

How to avoid inheritance tax on property

What if the heirs can't afford to pay IHT?

Life insurance in trust

Types of life cover

What is inheritance tax?

At its simplest, inheritance tax (IHT) is an amount of money that’s owed to HMRC upon a person’s death before the remainder of their estate can be passed to their heirs.

Does everyone pay inheritance tax?

While every estate is subject to inheritance tax, the reality is that only the minority of estates reach the thresholds after which the tax is due.

In order to understand inheritance tax, it’s important to know the terms:

• Estate – this means everything of value that’s left behind by a person when they die. It is a total of the value of their house, savings and current accounts, car(s), jewellery, artwork, personal collections, etc. There is no need to liquidate and sell their assets to form the estate, but they are all evaluated and calculated, and the total is defined as the value of the estate.
• Heirs – the people who the estate will pass on to.
• Inheritance tax – the amount owed to HMRC calculated from the estate value.
• Nil Rate Band (NRB) – the lowest threshold under which there is no tax owed. Currently (2019/20 year), the NRB is set to £325,000. So if your estate value comes to a total that’s below this amount, no inheritance tax will need to be paid.
• Residence Nil Rate Band (RNRB) – an additional threshold for zero tax offered if the home part of the estate is passed to surviving descendants. The RNRB is increasing every year and currently stands at £150,000 for the 2019/20 tax year.

Inheritance is paid by all heirs except a direct spouse or civil partner of the deceased. Inheritance tax is also waived for any part of the estate that is passed to a charity.

How much is inheritance tax?

Inheritance tax is calculated as 40% of the estate value beyond the total of the nil rate band plus any applicable residence nil rate band.

Examples of inheritance tax amounts:

Example 1 – An estate valued at £230,000 of which £210,000 is the family home.

As the total estate value falls under the nil rate band, the total inheritance tax owed will be zero.

Example 2 – An estate valued at £500,000 of which £430,000 is the family home.

If the heirs are direct descendants (either children or grandchildren) of the deceased, then the RNRB will apply, giving a total threshold of £475,000. This estate is valued at £25,000 above that threshold so the tax will apply to that final £25,000, making a total owed of £10,000.

If the heirs are not direct descendants, then only the NRB of £325,000 will apply, leaving a taxable value of £175,000 and total tax owed of £70,000.

Example 3 – An estate valued at £600,000 made up entirely of savings and investments.

With no home, there is no need to apply RNRB even if the heirs are direct descendants. In all cases where IHT applies, it will be calculated as 40% of £275,000 for a total tax of £110,000.

Example 4 – An estate valued at £750,000 of which £520,000 is the family home and the remains are to be gifted to a charity.

The £230,000 that is to be given to the charity is exempt from inheritance tax.

The remaining £520,000 house is passed on to the children and has both NRB and RNRB applied, for a total IHT threshold of £475,000. The remaining £45,000 is taxed at 40% for a total of £18,000 owed.

How can life insurance help to avoid inheritance tax on property?

A basic life insurance policy will form part of the estate once it is paid out. Thus, if you have a life insurance policy with a sum assured of £400,000 then there is no doubt that the allowances for inheritance tax will be passed and something will be owed to HMRC.

However, life insurance also offers something very special – a way to pay the inheritance tax without having to liquidate part of the estate.

Liquidation of the estate - what happens if the heirs cannot afford to pay inheritance tax?

Inheritance tax, like other taxes, is an immutable debt that isn’t easily sorted out through payment plans. While it is possible to request a staggered payment structure, it will be subject to interest and may work out a significant and debilitating debt.

In most cases, if there is not enough liquid cash available to pay the inheritance tax on property, the assets (typically the house) must be sold in order to pay for the inheritance tax.

This situation can lead to people losing their homes. If a family is living in a home and the surviving parent dies (or both parents die simultaneously), then despite inheriting the home, they may be unable to pay the inheritance tax and have to sell the house to cover the bill. On top of all the other emotional suffering and distress, this can be very difficult to deal with.

The simple truth is, however, that the inheritance tax must be paid first, and the emotional suffering of the surviving descendants is rarely a reason for putting it off.

Life cover in trust – the perfect remedy for inheritance tax

By having a life insurance policy in place, the liquid funds can be paid to the heirs in order to cover the anticipated inheritance tax. For example, should £100,000 be anticipated then a life insurance policy of £100,000 could be put in place to pay for it.

But what about the inheritance tax on life insurance?

The reality is that to guarantee £100,000 in cash, the inheritance tax rules mean that £167,000 would be needed by the life insurance policy (the remaining £67,000 is a 40% inheritance tax payment). Unless the life insurance policy was put into trust.

If the life insurance policy was in trust with one (or more) of the heirs as the beneficiary, then it would be outside of the estate and not subject to inheritance tax. A life insurance policy in trust for £100,000 would be passed as a clear tax-free sum to the heir who could then use the money to pay for the inheritance tax on the home and prevent its unfortunate sale. Phew!

Types of life insurance – which is best suited to cover the inheritance tax?

There are different types of life insurance cover, each best suited to provide an answer for a given problem: decreasing term insurance is great for paying off mortgages, over 50s cover is perfect for those with previous medical conditions, etc. In the case of inheritance tax, the best product is simple Whole of Life cover.

Whole of life cover has no end term, meaning that no matter when you die, it will pay out – whether that’s when you are 30, 60, 90 or 120!

If you are looking to pass a sizeable estate to your heirs, then you do not want a level of cover that stops once you retire or one that decreases in size. Whole of life is the simplest-to-understand type of life insurance – you pay a regular monthly premium and it ensures the right payout to cover that final hit of inheritance tax. Just make sure you estimate reasonably when calculating your cover to provide the amount needed.

You may also want to look into index-linking your insurance policy. This will make sure that your insurance payout adjusts and increases in-line with inflation. Read our detailed guide What is Index-Linking in Life Insurance? for more information on the subject.

How Quick Quote Protect’s advisors can help

Give us a call today to discuss your inheritance tax. Our advisors are personal finance experts and can help you through the process to get you the perfect cover to suit your situation, making sure your heirs are able to keep the assets and not find themselves forced to liquidate and lose the gifts you are passing down to them.

Use our short contact form to have someone call you back at a convenient time or pick up the phone and call us now to see how we can help you!