Life Insurance Payments: Taxable In The Uk?

Life insurance payouts are usually exempt from tax in the UK. However, in certain circumstances, they can be subject to inheritance tax. This is a tax on the value of a person's estate above a certain threshold. The current threshold for inheritance tax is £325,000 per person, and it is charged at a rate of 40% on anything over that amount. There are ways to avoid paying inheritance tax on a life insurance payout, such as by putting the policy in trust or leaving everything to a spouse or civil partner.

Life insurance payouts are usually tax-free

Tax-Free Payouts

In the UK, life insurance payouts are generally not taxed as income or capital gains. This means that the beneficiary of a policy will not need to pay income tax on the money they receive.

Inheritance Tax

However, the payout may be subject to inheritance tax (IHT). If the payout and the deceased's estate exceed the IHT threshold, then IHT will be applied to the amount over the threshold. The current IHT threshold is £325,000 per person and the tax is levied at 40%. For example, if the deceased's estate is worth £500,000, they would face an IHT bill on anything over £325,000 – i.e. £175,000. 40% of that is £70,000, which would be owed in IHT.

Mitigating Inheritance Tax

There are ways to mitigate the impact of IHT on a life insurance payout. One way is to set up the policy in trust, which separates the payout from the rest of the estate. This can be done at any time, but it is recommended to do it as early as possible, preferably when the cover is first taken out. By placing the policy in trust, the proceeds of the policy will not be included in the value of the estate for IHT purposes. It is also important to note that if you leave your home to your spouse or civil partner, there is no IHT to pay.

Inheritance tax may be applied to life insurance payouts

Life insurance payouts are generally tax-free for the beneficiary, but there are some instances where inheritance tax may be applied. Inheritance Tax (IHT) is a tax on the estate (property, possessions, and money) of a person who has died. This tax is typically levied when the deceased's estate exceeds a certain value, and life insurance payouts can form part of this calculation. If the life insurance policy is written into trust, it can be kept separate from the rest of the estate for IHT purposes, which may provide some tax advantages. Writing a policy in trust means that the policy and its payout are legally distinct from the rest of your estate and can help speed up the payout process, too.

In the UK, the current IHT threshold is £325,000 (as of the 2023-2024 tax year). This means that if your estate, including any life insurance payouts, is valued above this amount, it may be liable for IHT. The standard IHT rate is 40% and must be paid on any value above the threshold. For example, if your estate, including life insurance, is valued at £500,000, the IHT bill would be £70,000 (40% of £175,000, which is the difference between £500,000 and the £325,000 threshold). This tax is typically paid by the executor of the will out of the estate's assets before the beneficiaries receive their inheritance.

There are some exemptions and reliefs that can reduce the IHT liability on life insurance payouts. For example, if the policy is made payable to a spouse or civil partner, it is generally exempt from IHT, as transfers between spouses are usually free of this tax. Additionally, if the policy is made payable to a charity, it is also exempt from IHT. Another relief to consider is the 'normal expenditure out of income' rule, which allows you to make regular gifts from your surplus income, including life insurance premiums, that may be exempt from IHT if certain conditions are met.

To calculate whether your estate may be liable for IHT, you should add up the value of all your assets, including property, investments, possessions, and the expected value of any life insurance payouts. From this total, you can then subtract any debts, such as an outstanding mortgage, to get an estimate of the value of your estate for IHT purposes. If the value exceeds the IHT threshold, you may want to consider steps to mitigate the tax liability, such as writing your life insurance policy into trust or increasing your contributions to charitable causes.

Life insurance policies can be written 'in trust' to avoid inheritance tax

Life insurance payouts are usually tax-free. However, in certain circumstances, they can be subject to inheritance tax (IHT). If the payout and the deceased's estate exceed the IHT threshold, then the amount over the threshold is taxed at 40%trust to avoid inheritance tax. A trust is a legal arrangement where ownership of certain assets, including any outstanding debts, is transferred to a trustee, who can be a solicitor or a family member. The trustee ensures that the assets go to the named beneficiaries, such as a partner or children. This means that the money goes directly to the intended recipients rather than being taxed.

Writing a life insurance policy in trust offers several benefits. Firstly, it helps your family avoid a large tax bill on the payout they receive. Secondly, it speeds up the payout process by bypassing the probate procedure, which can be lengthy. Additionally, it allows you to specify your wishes regarding the distribution of the funds. You can choose who will receive the payout and how much they will receive.

To put your life insurance policy in trust, you can contact your insurance provider, who will typically offer this option at no extra charge. It is best to do this as soon as possible, ideally when you first take out the policy. While there are no time restrictions, making late changes solely to avoid tax may be ruled against.

It is important to note that writing a life insurance policy in trust is an irrevocable act. Once the policy is in trust, you cannot adapt or change it. Therefore, it is recommended to carefully consider your needs and seek professional advice before proceeding.

The estate of the deceased may be subject to inheritance tax

Life insurance payouts are usually exempt from tax in the UK. However, in certain circumstances, the payout may be subject to inheritance tax (IHT).

The inheritance tax threshold is currently £325,000 per person. So, if the total value of the deceased's estate is more than £325,000, then any amount above this will be taxed at 40%. For example, if the deceased's estate is worth £500,000, they would face an IHT bill on anything over £325,000 – which is £175,000. 40% of that is £70,000, which is what would be owed in IHT.

The estate includes anything owned by the deceased, including property, cars, money, jewellery, and the proceeds of any life insurance. It is important to note that the residence nil-rate band (RNRB) is currently £175,000 and applies when the deceased leaves their primary property to a direct dependent, such as a child or step-child. Within a couple, these allowances are passed on, so if one person passes away and leaves their assets to their spouse, their spouse then has two lots of IHT allowance and two lots of RNRB. That is (2 x £325,000) + (2 x £175,000) = £1m. It is important to note that this only applies if the first person leaves all their assets to their spouse and if the spouse leaves the home to children or grandchildren. If the will passes the estate among other beneficiaries, such as siblings or close friends, then this doubling-up of allowances does not apply.

To avoid inheritance tax on the life insurance payout, individuals can place their life insurance policy in trust. This is a legal arrangement that allows the policy to be given to trustees, who become the legal owners and look after it on behalf of the beneficiaries. This ensures that the life insurance payout is separate from the estate and will not be subject to inheritance tax. It also allows the individual to control who gets the money and usually leads to a speedier payout as it does not need to go through probate.

Life insurance payouts can be taxed differently depending on the arrangements of the insured

Life insurance payouts are usually exempt from tax in the UK. However, in certain circumstances, they can be taxed differently depending on the arrangements of the insured.

The main form of tax that can affect the payout of a life insurance policy is inheritance tax (IHT). This is a tax usually payable on all assets that form part of the insured person's estate, which may include any potential life insurance payout. If the payout and the existing estate value exceed the threshold for paying no inheritance tax, then any amount over the threshold would be liable for inheritance tax. The current IHT threshold is £325,000 per person, and the tax is levied at a rate of 40%.

To avoid paying inheritance tax on a life insurance payout, you can place the policy in a trust. A trust is a legal arrangement that allows you to give your policy to trustees, who become the legal owners and manage the payout on behalf of the beneficiaries. The trustees can be solicitors or family members, and they ensure that the money goes to the intended beneficiaries without being considered part of the estate. This can also result in quicker access to the funds since it bypasses the probate process.

It is important to note that income tax and capital gains tax are generally not applicable to life insurance payouts. However, if you have a non-qualifying policy, which usually includes some sort of investment element, you may be liable for income tax at the higher and additional rates.

Frequently asked questions