Inheritance tax mistake costs families £350m – are you making this simple error?

Thousands of families are overpaying inheritance tax on life insurance policies, according to new figures, because they make a simple mistake when they take them out.

Nearly 7,500 families paid inheritance tax on life insurance policies in 2022/23, according to HMRC. But many would have escaped a bill if their policy was written into trust.

A trust is a way of ringfencing your assets. When a life insurance policy is written in trust, the payout from the policy can be sent directly to your beneficiaries, rather than to your legal estate. This means they can avoid inheritance tax on the amount paid out from the policy.

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Of the 31,500 estates that paid inheritance tax in 2022/23, nearly a quarter of them (7,458) included life insurance policies, according to HMRC figures.

These life insurance policies were worth a total of £865 million, meaning up to £346 million of inheritance tax may have been paid on them, if the full rate of 40% inheritance tax was due.

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

Sean McCann, chartered financial planner at financial advice firm NFU Mutual, which analysed the figures, said: “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%.”

Should I put my life insurance in trust?

With inheritance tax (IHT) set to apply to pensions from April 2027, and the scrapping of 100% business property relief and agricultural property relief from April 2026, legacy wealth planning is becoming increasingly tricky.

Putting life insurance policies into trust is relatively straightforward, however, McCann said. If you have life insurance and it isn’t in trust you can 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,” he added.

The only time when this wouldn’t be the case is if you are seriously ill when you put the policy in trust and die within seven years.

Under those circumstances, HMRC could argue the policy had a value when you put it into trust and seek to include that value in your estate and charge inheritance tax, McCann pointed out.

More families hit with inheritance tax bills

With house prices and other asset values at record levels, more families are finding themselves with an inheritance tax bill when their loved one dies.

About 3,700 more deaths resulted in inheritance tax in 2022-2023, according to the latest data from HMRC. This brings the total to 31,500 IHT-paying estates, an increase of 13% on the previous year.

The proportion of deaths liable for inheritance tax also rose to 4.62%, an increase of 0.23 percentage points compared to the tax year before. This proportion is now broadly equal to the previous 2016-2017 high.

Inheritance tax is normally due on assets above the £325,000 nil-rate threshold each person has, though in addition to this, there is the £175,000 nil-rate main residence threshold per person.

When combined, the allowances mean couples can pass on as much as £1 million inheritance tax free to their children. Spouses are already exempt from inheritance tax, regardless of the amount.

But with the tax-free allowances frozen until 2030, 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,” said McCann.