Understanding life insurance inheritance tax

Life insurance is a key part of financial planning, providing peace of mind that your loved ones will be financially protected when you pass away. But when it comes to receiving a life insurance payout, many people wonder: is it subject to tax?

In the UK, the taxation of life insurance payouts can vary depending on the structure of the policy, who the beneficiary is, and whether the payout becomes part of your estate.

In this guide, we’ll answer common questions about whether you pay tax on life insurance payouts, how inheritance tax comes into play, and what you can do to minimise the tax burden on your beneficiaries.

Life insurance inheritance tax

One of the biggest concerns for people leaving a life insurance policy to their loved ones is inheritance tax. In the UK, inheritance tax (IHT) is charged at 40% on estates worth more than £325,000 (or £650,000 for married couples).

So, what does this mean for life insurance inheritance tax?

When is life insurance subject to inheritance tax?

If your life insurance policy is not written in trust, the payout will typically form part of your estate when you die. This means that if the total value of your estate (including the life insurance payout) exceeds the inheritance tax threshold, the payout could be subject to inheritance tax at 40%.

For example, if your estate is worth £400,000 and your life insurance payout is £200,000, the total estate would be £600,000. This would mean anything over the £325,000 threshold is subject to inheritance tax, potentially reducing the amount your beneficiaries receive.

How can you avoid inheritance tax on life insurance?

One of the best ways to prevent life insurance inheritance tax is by writing the policy in trust. When your policy is in trust, it is kept separate from your estate, meaning the payout goes directly to your chosen beneficiaries without becoming part of the estate and being taxed.

Setting up a trust is relatively simple and can be done at the time of purchasing the policy or later on. This ensures your beneficiaries receive the full payout without losing a portion of your life insurance to inheritance tax.

Tip: Speak to a financial adviser or solicitor about setting up a trust for your life insurance policy to protect your payout from inheritance tax.

Income tax and capital gains tax on life insurance

Generally, life insurance payouts in the UK are not subject to income tax or capital gains tax.

The lump sum your beneficiaries receive upon your death is typically tax-free, which means they don’t need to worry about paying additional taxes on it.

Whether you choose term or whole life insurance, writing the policy in trust is key to keeping the payout separate from your estate and protecting it from inheritance tax.

However, while life insurance payouts themselves are not directly taxed, the overall value of your estate could trigger tax liabilities if it exceeds the IHT threshold.

Tax on death in service benefits

Life insurance policies offered as part of an employment benefits package, also known as “death in service” benefits, may raise questions about taxes.

Are death in service payouts taxable?

In the UK, death in service benefits are typically paid out tax-free to the employee’s beneficiaries, as long as the benefit is structured in a way that keeps it outside the employee’s taxable income.

However, as with other life insurance policies, if the death in service payout is included in your estate, it could become subject to inheritance tax. To avoid this, many employers set up death in service benefits in trust, meaning the payout will go directly to your beneficiaries without being taxed.

Does death in service count as a taxable benefit?

Generally, having a death in service benefit as part of your employee package is not considered a taxable benefit, and it will not affect your income tax. The payout to your beneficiaries is also tax-free, making it a valuable addition to any employment benefits package.

Tip: If you receive death in service benefits through work, check whether it’s held in trust to avoid any inheritance tax implications for your beneficiaries.

Final thoughts

In the UK, life insurance payouts are generally tax-free for your beneficiaries, but life insurance inheritance tax can come into play if the payout forms part of your estate.

Writing your policy in trust ensures the payout avoids inheritance tax and can be used to provide financial security, such as covering living expenses or paying off debts.

Additionally, life insurance provided through an employer (such as death in service benefits) is usually tax-free, both in terms of the payout and how it impacts your income.

If you’re planning to take out life insurance, especially if you’re over the age of 60, it’s also important to assess how much life insurance you need and review your options to protect your payout from inheritance tax.