Life insurance tax | Is life insurance taxable?

Is life insurance tax free? Although life insurance payouts are usually exempt from tax, in the wrong circumstances life insurance payouts can be subject to inheritance tax.

Read our guide to learn about life insurance and tax, and how to keep your life insurance tax free.

Are life insurance payouts taxable?

When a life insurance policy pays out money, the payout itself is tax free. But it’s not quite that simple. 

Although the money goes to the named beneficiary of the policy, for tax purposes the estate of the insured person - the person who passes away - receives the payout. 

There is no income tax to pay tax on a life insurance payout and no capital gains tax. But for tax purposes the money transfers to the beneficiary - usually the next of kin or whoever was named in the will. 

In some circumstances the estate of the person who passed away may be subject to inheritance tax (IHT)so the person who receives the life insurance payment may find tax has to be deducted. IHT is a whopping 40%, so a £200,000 life insurance policy might only be worth £120,000 after tax.

Who benefits from a life insurance policy in the UK?

Someone who receives a life insurance payout is known as a beneficiary. Beneficiaries are named on an insurance policy as the people who will benefit from any payout if a claim is made on a life insurance policy in the UK, the claim is accepted and paid out.

People take out life insurance protection to ensure that their family or dependants have a cash payout should they no longer be around.

Do I have to pay taxes on money received from a life insurance policy?

When a life insurance policy payout is made in the UK, it's not taxed as either income or capital gains. However, inheritance tax (IHT) may be applied to part or all of it.

Your estate is the money, investments, pensions, assets, property and anything else of value that remains after your death. 

Whether or not a life insurance policy payout is taxed before your family and loved ones get to use it depends on the total value of your estate, who you leave your estate to, and whether your life insurance is in a trust. 

Will my life insurance be taxed?

In the UK after you die your assets – otherwise known as your 'estate' – can be passed on to friends and family. 

However, part of your estate might be subject to inheritance tax depending on the total value of your assets and your personal circumstances. 

Your estate is a sum of the things you own, including property (only if you've paid off the mortgage in full), jewellery, investments, cars, and anything else that you have full ownership of that you have the right to pass on to somebody else.

These are considered gifts and upon your death they are potentially taxable if they exceed certain allowances. Several factors come into play:

• The inheritance tax (IHT) threshold is currently £325,000 per person. So if the total value of your estate is more than £325,000 then any amount above £325,000 may be taxed at 40% 

• You may leave your primary property (the home in which you live) to your spouse with no tax implications, meaning the IHT amount only covers assets other than your main home. Note: you must be in a legal marriage or civil partnership, not just cohabiting, to get this benefit

• The residence nil rate band (RNRB) is currently £175,000. This applies when you leave your primary property (the home in which you live) to a direct dependent. Note: this may be your child, step-child or their descendants (your grandchildren)

• Within a couple, these allowances are passed on, so if one person passes away and leaves their half of their home and all 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. Note: 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 your will passes your estate among other beneficiaries, such as brothers or sisters, nephews or nieces, or close friends, then this doubling up of allowances does not apply

• If the value of the life insurance payout takes the person who passed away above the tax-free limits after taking into account all the possible allowances, then any amount above the allowances will be subject to IHT. The current rate of IHT is 40%

Life insurance and IHT example 1

A husband passes away. He leaves £100,000 of assets and half the £800,000 home to his wife. There is no tax to pay. Even if he had life insurance worth an extra £200,000, that would make his non-property assets worth £300,000 so there would still be no IHT.

When his wife passes away, she leaves £200,000 of assets and a house worth £800,000 to her children. The total legacy is £1m but she has two IHT allowances of £325,000 plus two RNRB allowances of £175,000, all worth a total of £1m. That means there is no tax to pay. 

However, if she received £200,000 of life insurance, that would be over their total allowances so would be subject to IHT at 40%.

Life insurance and IHT example 2

A single person passes away leaving £100,000 of assets and a home worth £800,000. They have one IHT allowance of £325,000 and no RNRB. That means £675,000 will be subject to IHT. If they received £200,000 of life insurance that too would be taxed at 40%.

How do I get tax-free life insurance?

If your life insurance policy is written 'in trust' it will be separate from your estate and will avoid any inheritance tax. Most life insurance policies are not written in trust, which means that if you already have taken out a policy, it's likely that it will be, potentially, subject to tax.

However, you can resolve this fairly easily. If you speak to your insurer and ask if you can write your insurance policy in trust, they should be able to help you. They will have standard trust wordings and will be used to doing this for customers.

This essentially means that someone else manages your payout, and that, legally speaking, you are no longer in charge of the payout (which is why it would have been considered as part of your estate previously). However, you still have influence over how it is distributed and who receives it though a ‘letter of wishes’ telling the trustee how you would like the money spent.

Your trustee can be a solicitor or someone in your family, and they will handle your payout according to your wishes. There is no change in the basics of how the payout is managed when you write it in trust; it only means that legally you will not have to pay tax, as it is no longer part of your estate.

The money will be distributed the way you want it to be, and theoretically, your family should receive the money quicker as it does not need to be subject to the same tax and legal proceedings as the assets in your estate.

But don’t wait until the last moment to make this change. If you were diagnosed with terminal cancer and then tried to set up a trust to avoid tax the taxman would rule against you. You cannot make late changes just to avoid tax.

Putting life insurance money in a trust

When you put your life insurance payout in a trust it is exempt from inheritance tax because it's separate from your estate.

This trust is managed by trustees, who will be chosen by you. This can be a solicitor or family members. They can then distribute the money according to your wishes.

You may also want to write your life insurance policy in trust for a child in your family, who will only be able to access the money once they reach adulthood.

If you plan your taxes accordingly, you could even arrange for your life insurance payout to help pay the tax bill on your estate after you die. For example, if the value of your estate is above the inheritance tax threshold, your family will have to pay tax on that amount. Your life insurance payout will be exempt from tax and could be used to cover the tax bill on the estate.

If your finances are quite complicated then it is best you speak to an independent financial adviser to help you find a solution that works for you regarding taxes and your estate.

Calculating your inheritance tax

If you believe your family is likely to owe inheritance tax on your estate after you die, then it is important when taking out life insurance to calculate how much that tax bill might be.

Your life insurance payout is likely to go towards paying for debts, funeral expenses and possibly helping your family get by over the few months after you die. The amount of the payout may not be enough if they also receive a large inheritance tax bill for your estate.

First, if your life insurance policy is in trust then it will be exempt from tax. Secondly, calculate what your estate is worth and see if you will have to pay tax.

The average property price outside of London is almost half of the tax threshold, with London properties being around the same value as the tax threshold. So with this in mind, if you fully own a property then it won't be too difficult for your other assets to put you in the inheritance tax paying bracket.

If you want to give any gifts away while you are alive they might still be due tax after you die if you gave them away within seven years prior to your death. So just be aware that you won't necessarily be avoiding tax if you give away some of your assets before you die.

*Based on £150,000 of level-term cover for 25 years for a 30-year-old non-smoking male with no pre-existing medical conditions (March 2023)

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