The good news for UK expats is that the proceeds, should your beneficiaries need to make a claim on the policy, are not usually subject to either UK income tax or capital gains tax.

The bad news, unfortunately, is that UK inheritance tax (IHT) may be due if the pay out from the policy ends up counting towards the value of your estate.

Many UK expatriates confuse domicile with residence. UK IHT may still be payable on worldwide assets even if an UK citizen passes away even if they have been living and working offshore for many years.

Here’s a closer look at IHT, plus tips on how to reduce paying IHT on the proceeds of a life insurance policy.

What is UK IHT?

IHT is a tax applied to the ‘estate’ of a person who has died. In this context, an estate can include property (such as the family home), other possessions (such as cars) and money. The latter potentially includes the proceeds from a life insurance policy pay-out.

IHT isn’t usually levied if the value of an individuals estate falls below the ‘nil rate band’ which currently stands at £325,000. Nor does it apply where all of an estate’s proceeds have been left either to an UK domiciled spouse or civil partner, or a third party with exempt beneficiary status (such as a charity).

However, if your estate is worth more than £325,000 and the above scenarios don’t apply, then the part of your estate above the threshold could be liable for IHT at an eye-watering rate of 40% on your worldwide estate.

IHT and married couples

Married couples and those in a civil partnership can share their thresholds and transfer the unused element of their IHT-free threshold to their partner when they die. This means that a married couple or registered partnership can pass on £650,000 before IHT becomes payable.

A transfer from spouse to spouse where both individuals are UK domiciled is usually IHT free. However, it is important to note if one partner is not from the UK and does not have UK domicile, a transfer by a UK domiciled spouse to a non-UK domiciled then the exemption is capped at an amount equivalent to the nil rate band, currently £325,000. Thus, a UK domiciled spouse is able to transfer up to twice the value of the nil rate band to his non-UK domiciled partner before incurring a tax liability.

Do I pay IHT on life insurance?

The proceeds from a life insurance policy will form part of your legal estate unless you take action to prevent this happening. If a life insurance pay-out means that the value of your estate exceeds the £325,000 IHT threshold, the part of your estate above this will be liable to tax at 40%.

That potentially means a significant reduction in the pot of money that was originally intended to financially support your loved ones and dependents in the event of your passing away. Fortunately, some straight forward financial planning can rectify this scenario.

Draw up life insurance ‘in trust’

The easiest way to reduce or avoid IHT being charged on life insurance is to have the policy written ‘in trust’. This keeps any pay-out from being included in your estate.

A trust is a legal arrangement which appoints trustees, such as a solicitor, family members and friends, to oversee the policy on behalf of beneficiaries until the moment comes when they are set to benefit.

Writing a policy in trust should ensure that the pay out reaches loved ones quickly as it side-steps probate – the legal process and paperwork associated with sorting out a dead person’s estate. Often the policy will pay out to the beneficiaries within 30 days of production of a valid death certificate without having to go through UK probate.

Setting up a trust should be straightforward and your life insurance provider or financial planner ought to be able assist with the process. It usually requires nothing more than a signature on your part. There shouldn’t be any additional cost for you to do this.

Many financial planners will routinely ask if you want to have your policy written ‘in trust’ during the purchase process.

Generally speaking, it makes sense to set up a trust when the life cover is first taken out. But it’s possible to put a policy into trust at any time.

Can I use life cover to pay IHT?

When you die, any IHT owed needs to be paid before loved ones are granted access to your estate. This means they could be forced to foot a bill of thousands of pounds in one go. This may mean some of your assets may need to be sold before access to the estate is granted

If you know that your beneficiaries are going to be liable for IHT in the event of your passing, you could take out a ‘whole-of-life’ insurance policy to offset the full amount of the IHT bill.

In addition, if you are leaving a property to a direct descendant, for example a child or a grandchild, you can benefit from an additional tax-free allowance per person of £175,000. This has the effect of increasing a couple’s combined threshold to £1 million. cover pays out whenever you die, in contrast to term life insurance. which only pays out if you die during a specified period.

To avoid the proceeds incurring IHT, a whole-of-life policy would again need to be written in trust.

IHT planning can be a complicated business. An independent financial adviser can help with tax and estate planning to ensure that your wishes are carried out and to maximise the proceeds your beneficiaries eventually receive.