Life Insurance Payments: Are They Tax-Exempt?

Life insurance is a complex product, and the tax implications can be confusing. In the UK, there is no specific tax on life insurance, and in most cases, the payout from a life insurance plan is tax-free. However, there are certain situations where tax may be payable. For example, if the policy is not set up in trust, the payout may be subject to inheritance tax if it forms part of the deceased's estate and exceeds the inheritance tax threshold. Additionally, if the policy includes an investment element, it may be considered a 'non-qualifying' policy, which could have tax implications. Putting life insurance plans in trust can help ensure that the right people receive the correct amount of money at the right time and can also provide tax benefits.

Inheritance tax

However, there is no IHT payable on anything left to a spouse or civil partner. Additionally, if you leave your home to your children or grandchildren, the threshold increases to £425,000 or even £500,000 with the 'residence nil-rate band' (RNRB). This means that if you die, there will only be an IHT bill on anything above £500,000.

If you want to avoid your beneficiaries having to pay IHT on your life insurance payout, you can place your life insurance policy in trust. This way, the payout won't be included when calculating your estate after your death. A trust is a legal agreement where you hand over your policy to trustees, who become the legal owners and manage it on behalf of the beneficiaries. It is recommended to set up a trust when you first take out life cover, although it can be done at any time.

Another way to avoid federal taxation on your life insurance proceeds is to transfer ownership of the policy to another person or entity. This can be done by choosing a competent adult or entity as the new owner and completing the necessary forms from your insurance company. However, it is important to note that this is an irrevocable decision, and you will give up all rights to make changes to the policy in the future.

Non-qualifying policies

If you have a non-qualifying policy, you can withdraw up to 5% of the amount invested annually before the policy reaches maturity without immediate tax liability. To make the most of this advantage, it is recommended that you speak to an expert.

To avoid paying tax on your life insurance proceeds, you will need to transfer ownership of the policy to another person or entity. This can be done by putting your life insurance policy into a trust, which is a legal arrangement that allows you to give your policy to trustees who become the legal owners. They then look after the policy on behalf of your chosen beneficiaries. Trustees can be family members, friends, or a solicitor. Your insurance provider should be able to help with this process, which is typically straightforward and free of charge. It is best to put your policy in a trust as early as possible, preferably when you first take out the cover.

There are several benefits to putting your money in a trust. Firstly, it allows you to control who gets the funds from your life insurance policy, as the money will be paid directly to your chosen beneficiaries rather than your legal estate. Secondly, it often results in a faster payout as the policy is not part of your estate and therefore does not need to go through probate, which can be a lengthy process. Finally, placing your policy in a trust means that you can make changes to it in the future, whereas normally, once a policy is in a trust, it cannot be altered.

Interest on the lump sum

In most cases, beneficiaries are not required to pay taxes on their life insurance payout. However, there are exceptions. If the beneficiary receives interest on the lump sum during the period between the death of the policyholder and the transfer of the funds, this interest is taxable. This is because income earned in the form of interest is almost always taxable.

For example, if the death benefit is $500,000, but it earns 10% interest for one year before being paid out, the beneficiary will owe taxes on the $50,000 growth.

If the policyholder elects to delay the benefit payout and the money is held by the life insurance company for a given period, the beneficiary may have to pay taxes on the interest generated during that time. This means that if the beneficiary receives the payout in instalments and the remaining portion earns interest, that interest is taxable.

To avoid paying any taxes on life insurance proceeds, a taxpayer must transfer ownership of the policy to another person or entity. This can be done by putting the policy in trust or by transferring ownership to another individual or entity.

If the policy is combined with a non-refund life annuity contract where a single premium is equal to the face value of the insurance paid, then the exclusion does not apply. For example, if the death benefit face value is $250,000, and the beneficiary elects to receive monthly payments instead of the lump sum amount, the additional interest received above the $250,000 face amount is taxable.

Spouse/civil partner exemption

If you are married or in a civil partnership, you can leave any amount of money or assets to your spouse or civil partner without paying inheritance tax. This is known as the spouse/civil partner exemption.

The exemption also applies to any unused inheritance tax allowance. This means that when the surviving spouse or civil partner dies, their estate will only be taxed if it is valued at more than a certain threshold. This threshold varies depending on factors such as whether they leave their home to their children or grandchildren.

For example, if you do not use any of your inheritance tax allowance, your partner's estate will only be taxed if it is valued at more than £650,000. If you leave your home to your children or grandchildren, the threshold can rise to £1 million.

It is important to note that the spouse/civil partner exemption only applies if you leave your entire estate to your spouse or civil partner. If you leave part of your estate to someone else, the exemption may not apply.

In addition, the exemption only applies to inheritance tax. Other types of tax, such as income tax or capital gains tax, may still apply to life insurance payouts. It is recommended to seek independent financial advice to understand the tax implications of your specific situation.

Writing life insurance in trust

Writing a life insurance policy in trust is a good way to protect your family's future in the event of your death. It is a straightforward legal arrangement that lets you leave assets to friends, relatives, or whoever you pick as beneficiaries. A trust is managed by one or more trustees (family members, friends, or a legal professional) until it pays out to your beneficiaries, either upon your death or on a specified date (e.g. when a child turns 18).

The main benefit of writing life insurance in trust is that it helps your family avoid a big tax bill and lengthy delays on the payout they receive. When assets are placed within a trust, you effectively give up ownership of them. They are now under the management of the trustees and are no longer classed as being part of your estate. This means that should you die, the insurance policy will be handled separately from your actual estate and won't be subject to inheritance tax if your estate is valued above the tax threshold.

There are two main forms of trust: a bare trust and a discretionary trust. In a bare trust, the money is held by a trustee, and all of the proceeds should go to the person or people you nominate when they turn 18 (or 16 in Scotland). A discretionary trust gives the trustee greater power to decide how much the beneficiaries get, how frequently they get the money, and any other conditions (such as when they are able to receive the money).

There are several advantages to putting life insurance in trust:

• You specify exactly where you want your money to go and when.
• It helps lower inheritance tax.
• Probate doesn't need to happen on the money from your policy.
• Payouts can be faster.

The main disadvantage is that it can be difficult to make changes once it's set up.

How to set up a trust

Firstly, choose your trustees, who tend to be family members. Alternatively, you can choose a company such as a trust company or solicitors to act as trustees if you pay them a fee. Next, decide which type of trust is right for you. Your options include discretionary trusts, absolute trusts, and survivor's discretionary trusts. Once your trust is set up, your trustees legally own the policy and must keep the trust deed safe. They will ultimately make a claim to your insurer when you pass away, so they will need the trust deed close to hand.

It's worth noting that there is no added cost to putting life insurance in trust with some providers. You can put your personal life insurance policy in trust when you take it out or at any time after that.

Frequently asked questions