Life insurance and tax

From inheritance tax to non-qualifying policies, our easy-to-understand guide looks at exactly what the rules are when it comes to paying tax on  life insurance.

From inheritance tax to non-qualifying policies, our easy-to-understand guide looks at exactly what the rules are when it comes to paying tax on  life insurance.

Mubina Pirmohamed
Life insurance expert
minute read
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Posted 27 JANUARY 2021

Do I have to pay tax on life insurance?

You shouldn’t need to pay income tax or capital gains tax on life insurance - whether the policy provides a lump sum or a regular source of income. But your life insurance pay-out might be subject to inheritance tax. That’s why it’s helpful to understand the tax rules on this.  

Life insurance and inheritance tax

As a taxpayer, everyone has the right to a tax-free amount on their estate – the value of everything they leave behind when they die. It means your beneficiaries won’t need to pay tax on anything up to that amount. The inheritance tax allowance was frozen at £325,000 per person in 2019/20. For anything above that amount, you’ll be charged 40% tax. 

Included in your ‘estate’ are your material possessions, such as cars, jewellery, money and proceeds of any life insurance. Your estate includes your home. But following a change made to the Inheritance Tax (IHT) rules, if you leave your home to your kids or grandkids, the tax-free threshold rises to £425,000. This means if you die, there would be an IHT bill only on anything above £425,000.

Placing your life insurance policy in a trust can help you avoid inheritance tax. A trust is a legal agreement that enables you to hand your policy to trustees, who take on the role of legal owners. They take care of your policy for the sake of your family.

Typically, your insurance provider should be able to assist you with the process of putting life insurance in a trust. Although there is no time restriction for placing your policy in a trust, it’s best to do it when you first get cover.

Benefits to putting your money in a trust include:

  • You decide who receives the funds from your life insurance policy. That means the money from your policy is paid directly to your family, and not to your legal estate. That helps you avoid inheritance tax.
  • Often, there’s a faster pay-out. If the policy doesn’t include part of your estate, you should be able to skip the typical legal steps that accompany a death, like probate. (Probate is the process of proving a last will and testament that the deceased made.) After the policy has been put in a trust, it can’t be adapted in the future. You should think carefully about whether putting your policy in a trust is your best option.

For more details about inheritance tax, see our inheritance tax guide

What if I die and leave a spouse or civil partner? 

When you die, your assets are transferred to your surviving partner along with any of your unused tax-free allowance. Their estate will only be taxed, after they pass away, if it’s valued at more than £650,000.

How could I reduce inheritance tax through life insurance?

You could pay less tax by getting a whole of life insurance policy. This type of policy is typically used to mitigate inheritance tax. That's the tax which has to be paid by a person who inherits money or property; or is taken as a levy on the estate of a person who’s passed away.

With this policy type, any pay-out amount should cover an inheritance tax bill. Learn more about the benefits of whole of life cover.

What else do I need to know about life insurance and tax?

The whole point of having life insurance is to make sure those you leave behind are financially secure, and one way to avoid inheritance tax could be to set up your policy ‘in trust’. By putting a life insurance policy in trust, you’re separating it from your estate, which means it can’t be included when it comes to totting up how much you have in total. 

Any assets in a trust will be overseen by ‘trustees’ who you can choose – they’ll make sure the money you’ve set aside in the trust goes to who it’s supposed to. Trustees can be family members, friends or your solicitor. It’s not complicated to do and your insurance provider should be able to help you.

How does a life insurance pay-out work?

Life insurance is typically paid out when you pass away. It can be paid out in one lump sum or at regular intervals – it depends on your policy. The amount of money paid out will depend on the policy and cover you’ve agreed on with your insurance provider. If you don’t yet have life insurance, our simple guide could help you find out how much cover you might need, based on your circumstances.

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