How to Structure Life Insurance as Part of Your Estate Plan

When planning for the future, life insurance is often viewed as a simple way to provide financial security for loved ones. However, when integrated thoughtfully, it becomes a powerful tool in estate planning. In the UK, improperly structured life insurance can actually increase your inheritance tax (IHT) liability. That’s why understanding how to structure your policy correctly is essential to protecting your wealth and ensuring a smooth transition for your beneficiaries.

Why Life Insurance Matters in Estate Planning

Beyond replacing lost income, life insurance can help cover the IHT bill your estate may face upon your passing. In the UK, if your estate exceeds the IHT threshold—currently £325,000 for individuals or up to £1 million for couples including the residence nil-rate band—any excess is taxed at 40%. If your policy isn’t structured properly, the payout itself could push your estate further into taxable territory. Used strategically, life insurance can help your heirs avoid having to liquidate assets like a home or business just to settle the tax.

Choosing the Right Type of Policy

There are several types of life insurance policies, but the most relevant for estate planning are level term insurance and whole-of-life insurance. Level term insurance pays a set amount if you pass away within a fixed time period, making it suitable for covering debts or a mortgage. Whole-of-life insurance, on the other hand, pays out whenever you die, making it ideal for covering a known future tax bill like IHT. For business owners, a relevant life policy may offer additional tax efficiency, allowing for premiums to be paid by the company without it being treated as a benefit-in-kind.

The Importance of Placing the Policy in Trust

Arguably the most important strategy for tax efficiency is writing your life insurance policy in trust. This ensures the payout does not form part of your estate and is therefore typically not subject to inheritance tax. More importantly, trust-held policies are not delayed by probate, meaning your beneficiaries can access funds quickly, which is critical when settling tax liabilities. Trusts also allow you to control how and when the payout is distributed. A discretionary trust, for example, gives trustees the flexibility to adapt to changes in your family circumstances or financial needs.

Aligning Your Policy With Your Tax Exposure

To maximise its value in estate planning, your policy should be sized to match your expected tax liability. If you anticipate an IHT bill of £200,000 based on your current assets and thresholds, a whole-of-life policy for that amount can ensure that your heirs are not burdened by an unexpected tax demand. It’s wise to also consider inflation and potential increases in estate value over time when determining your coverage level.

Regularly Reviewing Your Life Insurance Setup

Just like any part of your estate plan, your life insurance should be reviewed regularly. Life changes such as marriage, divorce, children, the sale of a property, or new tax legislation can all affect the suitability of your policy. What worked five years ago may no longer provide the same protection today. A financial adviser or tax consultant can help ensure that your policy still meets your goals and remains as tax-efficient as possible.

Final Thoughts

Life insurance can be much more than a safety net—it can be the backbone of a smart, well-structured estate plan. But it must be used correctly. Choosing the right policy, placing it in trust, and reviewing it regularly are key steps in ensuring it reduces, rather than increases, your tax burden. At Avalon Tax, we help clients navigate these complexities to ensure their wealth is preserved and transferred efficiently. If you’re unsure whether your life insurance is working in your favour, we’re here to help with expert, personalised guidance.