Are you making this easy mistake? An inheritance tax error costs families £350 million

If the worst occurs, life insurance can give your loved ones a crucial safety net

However, the policy must be written in trust in order to avoid inheritance tax on the payout.

According to recent data, thousands of families are overpaying inheritance tax on life insurance policies due to a straightforward error made when they withdraw them.

According to HMRC, in 2022 - 2023 inheritance tax was paid by nearly 7,500 families on life insurance policies. However, many would have avoided a bill if their policy had been put in writing.

One way to ringfence your assets is through a trust. A life insurance policy that is written in trust allows the payout to go straight to your beneficiaries instead of your legal estate. They can therefore avoid paying inheritance tax on the money that the policy pays out.

According to data from HMRC, nearly a quarter (7,458) of the 31,500 estates that paid inheritance tax in 2022 - 2023 had life insurance policies.

If the full rate of 40 percent inheritance tax was due, the 865 million total value of these life insurance policies would have resulted in up to 346 million in inheritance tax.

But if the policies had been put into trust, they wouldn't typically be included in the estate of the deceased and wouldn't be subject to inheritance tax.

In the event of a claim, using a trust can also result in a quicker payout because the family won't have to wait for probate, which can significantly impact dependents who depend on the money to pay their daily expenses.

"Many people purchase life insurance without advice, so they are unaware that if they don't put the policy in trust, it is included in their estate and could end up being taxed at 40 percent," stated Sean McCann, a chartered financial planner at the financial advice firm NFU Mutual, which conducted the analysis of the data.

Do I need to trust my life insurance?

Legacy wealth planning is getting harder given that 100% business and agricultural property relief will no longer be available starting in April 2026 and that inheritance tax (IHT) will start to apply to pensions in April 2027.

But it's not too difficult to put life insurance policies into trust, McCann said. If your life insurance isn't in trust, you can call your provider and request a trust form.

He continued, "There are typically no inheritance tax ramifications if you are in good health when you put it into trust, as the policy usually has no value."

This wouldn't be the case unless you passed away within seven years of putting the policy in trust and you were very sick at the time.

In those situations, McCann noted, HMRC might claim the policy had value when you placed it in trust and try to include that value in your estate and impose inheritance tax.

Bills for inheritance taxes are affecting more families.

More families are receiving inheritance tax bills after a loved one passes away because home prices and other asset values are at record highs.

Approximately 3,700 additional deaths in 2022 - 2023 led to inheritance tax, according to the most recent HMRC data. This raises the number of IHT-paying estates to 31,500, up 13% from the year prior.

In addition, the percentage of deaths subject to inheritance tax increased to 4 out of 62, which is a 0 out of 23 percentage point increase from the previous tax year. Currently, this percentage is about the same as the peak from 2016 to 2017.

Though there is also a 175,000 nil-rate main residence threshold per person, inheritance tax is typically due on assets over the 325,000 nil-rate threshold each person has.

Couples can leave up to £1 million in inheritance tax-free to their children when the allowances are combined. Regardless of the amount, spouses are already exempt from inheritance tax.

However, an increasing number of families will be caught in the net as the tax-free allowances are frozen until 2030.

McCann stated, "This makes it all the more important that families don't pay inheritance tax on life insurance policies needlessly."