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.

Debbie Thompson
Life insurance expert
minute read
Do you know someone who could benefit from this article?
Posted 18 OCTOBER 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 2019/2020 and remains the same for 2020/2021. 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 can rise to £500,000. This means if you die, there would be an IHT bill only on anything above £500,000.

Putting life insurance in trust

If you don’t want your beneficiaries to pay IHT on your life insurance pay-out, consider placing your life insurance policy in trust. This will separate it from your estate, so it can’t be included when it comes to adding up how much you have in total. 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. Trustees can be family members, friends or your solicitor.

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.
  • Often, there’s a faster pay-out. If the policy isn’t 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, which can take months and even up to a year to resolve.) 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 and you may want to seek independent financial advice before making a decision.

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

What if I die and leave a surviving 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.

What if I die and I am co-habiting?

If you’re living together without being married, you and your partner won’t have the same exemption from paying inheritance tax as married couples and civil partners. Your surviving partner will have no legal claim on your estate unless you name them in your will as a beneficiary or you own property jointly. So, if you want them to inherit, you should make a will.

Even if you are unmarried, you can name your partner (or anyone else) as your beneficiary in your life insurance. Writing your life insurance in trust could be particularly helpful as you are separating the pay-out from the rest of your estate, so it’s not included in the total and won’t incur any inheritance tax. This can matter even more here because your partner will potentially have to pay inheritance tax on everything you leave them as they won’t have any exemption under the rules.

How can I use life insurance to help with tax planning for inheritance tax?

If your estate is large enough that inheritance tax will have to be paid after your death, setting up a whole-of-life insurance policy in trust can help your beneficiaries. Choose a policy that will pay out sufficient money to mitigate or cover the tax liabilities (and anything else you want to leave). Your family can use this to pay any tax owing and the money won’t have to come from the estate.

A whole-of-life policy guarantees that it will pay out whenever you die (so long as you keep paying the premiums) unlike a term insurance policy, which only pays out if you die during the fixed period of the policy. So, you can be sure that your family will receive a lump sum.

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.

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

If you’re self-employed or the director of a limited company, you’ll probably be able to claim some forms of life insurance as a business expense for tax purposes. However, it will need to be relevant business life insurance or key person insurance taken out through the business. You wouldn’t be able to claim your own personal policy as a business expense.

There are also some situations where some tax could be payable, for example:

  • If any interest has been earned on the lump sum during the period between the death of the policyholder and the transfer to the beneficiaries.
  • If your policy includes some element of investment. This is known as a ‘non-qualifying’ policy. It’s best to speak to an expert about what your options are if this applies to your situation.

Frequently asked questions

Do I have to pay Insurance Premium Tax (IPT) on my life insurance premiums?

No, most long-term insurance like life insurance, medical insurance and income protection insurance is exempt from paying the tax. VAT isn’t generally payable on insurance premiums either.

Do I pay tax on my workplace life-insurance policy?

No, you won’t pay tax if your employer offers you death-in-service benefits or group life-insurance benefits. Here your employer pays the premiums and whoever you name as a beneficiary will receive a payment if you die while you are still working for the company – often a multiple of your salary. HMRC don’t count this as a benefit in kind, so you don’t need to pay tax on it as part of your employee benefits package.

It is also typically written into a trust#, so it will not be included as part of your estate, and therefore your beneficiary/beneficiaries wouldn’t have to pay inheritance tax.

What are inheritance tax rates?

There’s no inheritance tax to pay if the value of the estate is within the allowance of £325,000 for the financial year 2020/2021. If anything above this limit is left to a spouse, civil partner or charity, again nothing will be payable. Otherwise, anything above this limit is charged at 40% inheritance tax.

You may qualify to pay inheritance tax at a reduced rate of 36% if you leave at least 10% of your net estate to charity.

Do I have to pay more for writing my life insurance in trust?

You won’t have to pay more for your policy for putting it in trust. However, you might want to pay for a legal advisor who can explain the process and help you understand how the trust will operate, to make sure it will do what you want it to.

Compare life insurance

Get a life insurance quote and start saving now

Get a quote
Get a life insurance quote and start saving now Compare life insurance