Life insurance is one of those gloomy topics that isn’t much fun to discuss. However, it could make a big difference to your loved ones should you expire sooner than expected. If you have a non-working partner or young children, how would they manage without your salary? Depending on the type of policy, life insurance can be relatively inexpensive. The peace of mind it can offer, though, is invaluable.
In this post, I’ll explain how life insurance works, who might need it, and what you can do to ensure any payouts aren’t taxed.
How does life insurance work?
In return for a monthly premium, your insurer promises to pay a lump sum in the event of your death. The cost of this premium depends on your age, health, and lifestyle. Other key factors are the type and term of the policy.
Level term – this means you’re insured over a specific period, e.g. 17 years. This could be timed to finish when your children have left university, or a dependent spouse starts receiving your pension.
Decreasing term – here, the value of the lump sum decreases over a fixed period. This type is suitable for mortgages where the amount owed reduces. It’s no good for interest-only loans.
Increasing term – you might want the amount to increase over a certain period to combat inflation. After all, £100,000 will be worth a lot less in 20 years’ time.
Whole-of-life – this policy pays out at any time. For this reason, it’s more expensive than the other types – the insurer will always have to stump up the money.
Family Income Benefit Insurance
There’s also a different kind of policy available that pays a monthly income, rather than a lump sum. Family Income Benefit insurance (FIB) works more like a pension and could make it easier for your dependents to manage their finances. You decide how much cover they need and for how long. The disadvantage is that there’s no lump sum to pay off large debts like a mortgage or car loan. There’s more information available on the Which? website.
How to save money on life insurance
First, think about what you actually need so you’re not paying more than necessary. And consider whether life insurance is appropriate. If you don’t have any dependents, what purpose is it serving? Speaking of which, check you’re not still paying for old policies that benefit ex-partners or children who are now wealthy YouTube stars.
Typically, life insurance covers the following costs:
- Outstanding debts, including mortgages
- Funeral expenses
- Future obligations, e.g. children’s education
- Partner’s loss of earnings if they’re self-employed
- Mitigation against inheritance tax
Make sure you don’t already have cover through an existing policy. For example, you might have taken out a mortgage protection product when you bought your house. Perhaps this is enough. But do find out whether you could get cheaper or better cover elsewhere.
Do you get life insurance cover through your employer or pension? Some schemes will pay your dependents several times your salary if you die while an employee. Check the terms and conditions, though, and remember that you’ll lose this benefit if you change jobs.
For the best deals on life insurance, take a look at MoneySavingExpert.
How to avoid paying Inheritance Tax on insurance payouts
Although there’s no income tax to pay on insurance payouts they are liable for Inheritance Tax. I covered this in detail recently, but essentially estates worth more than £325,000 are taxed at 40%. So, in certain circumstances, a £100,000 lump sum could shrink to £60,000. This situation can be neatly and legally avoided by writing the policy in trust. This means the asset (your potential lump sum) is held by trustees who make sure it goes to your beneficiaries, rather than to your estate. Another advantage is that those beneficiaries get the money much faster, as it doesn’t go through probate.
Some insurers offer the option of writing the policy in trust and often it’s free of charge. It’s usually possible to transfer an existing policy to trust, but you might need the assistance of a solicitor or financial adviser. One disadvantage with policies in trust is that you’re unable to change them after you’ve set them up. The policy is held by the trust, rather than by you, so you relinquish control.
Which? offers a detailed guide on writing life insurance policies in trust.
- Do you definitely need cover?
- If so, how much is required, and for how long?
- Are you covered by any existing policies?
- Should you write the policy in trust to protect it from inheritance tax?
In future posts, I’ll discuss other types of insurance, including Critical Illness Cover and Income Protection. Yes, more products that hopefully you’ll never need.
This post is for information only and does not constitute financial advice.