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Note From Kalen: This article is direct towards UK readers, so much of the information may not apply to US readers.
There are many good reasons to take out life assurance to ensure the financial security of your loved ones after your death. Most of these reasons centre around the provision of a lump sum that can be used by your surviving family for:
- Covering funeral and other final expenses – The average cost of a funeral in the UK is more than £3,600 and can be substantially higher. At an already difficult emotional time for your family, it is good to know that there are funds available to take care of everything without causing any undue hardship.
- Paying off debts, including the mortgage – Given the emotional impact your absence will have on your dependents, leaving them free of debt, with the house fully paid for, is at least one thing you can provision for.
- Covering children’s expenses, including school and university fees – Protect your children’s future by making adequate provision for their education, whether you are there in person or not.
- Replacing your income – Help preserve your family’s standard of living by ensuring sufficient money is available every month for living and household expenses.
- Paying inheritance tax (IHT) – Have funds available for your family to settle any IHT liability arising from the size of your estate.
So far, so good. But have you spotted the obvious flaw yet?
Let’s start with the inevitable. When you die, the value of the estate you leave behind will be calculated by the Government, taking into account your property assets, investments, cash deposits, vehicles, business assets and life assurance payouts. As it stands currently, your heirs will be liable for IHT on your estate on everything above £325,000, at a flat rate of 40%.
New IHT regulations are coming into force from April 2017 which will raise the IHT threshold. A new Family Home Allowance (FHA) will be gradually phased in over 4 years, which will include a tax free ‘main residence’ band worth an extra £100,000 in 2017 (rising to £175,000 by 2020).
The effect of this tax change is that from 2020, family homes worth up to £½ million (or £1 million on the death of the second spouse) will effectively be exempt from IHT just so long as the beneficiaries are direct descendants of the deceased.
This is great news for home owners, of course. However, in a booming housing market with an overall average property price of nearly £500,000 in London and for detached houses in the South East, it may not be enough to avoid inheritance tax.
And here’s the major rub: The payout from your life insurance forms part of your estate, meaning the extra sum will increase the value of your estate and therefore your IHT exposure – exactly the opposite of what you were intending to achieve!
According to industry figures, in excess of half a billion pounds are given to the Treasury in this way – and totally needlessly, as it turns out. So, what can you do?
If your life insurance policy is designed to pay off a specific debt, such as a mortgage, or if the money goes to your spouse which makes it IHT exempt, there’s no need to worry.
However, if the beneficiaries of your life insurance policy are your children or other loved ones, it is essential that you place your life insurance policy into a Trust. The Trust will not form part of your estate and the sums sheltered inside are not subject to tax. What’s more, the policy will pay out to the beneficiaries much quicker than going through the probate route.
Crucially, writing your insurance policy in trust means that when it pays out, your heirs have a lump sum available that can be used to pay some or all of the tax bill, in effect reducing your estate by the value of the policy.
Confused? You are by no means alone. Many people are unaware of the huge financial implications of putting your life insurance in trust, or failing to do so. For more information and to discuss your particular situation, make sure you take the advice of a professional tax adviser, insurance provider or solicitor.
Article provided by Mike James, an independent content writer working together with health sector insurance specialist Flexible Health, who were consulted over the information in this post.