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Life Insurance and Tax

Life Insurance and Tax

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Last updated: 10 February 2022

You shouldn’t have to pay income tax or capital gains tax on your life insurance, whether the policy pays out either a lump sum or a regular source of income. However, your life insurance payout could be subject to inheritance tax, so you need to understand what the rules are on this. 
Read on to find out about inheritance tax on life insurance, and how you can minimise its impact on your loved ones. What’s more, paying attention to this can make things much more efficient and easier for yourself, as well as your nearest and dearest.

How does inheritance tax affect life insurance payouts?

When you die, inheritance tax is normally due on the value of your estate above £325,000 if you’re single or divorced, or over £650,000 if you’re married or widowed. It is taken at the standard rate of 40%, unless you leave everything to your spouse. For instance, if you died and your estate was worth £500,000 there could be an inheritance tax bill of £175,000. 
Your estate is made up for everything you own. This includes cars, money and jewellery, as well as the proceeds of any life insurance policy. So, it’s worth making sure that the payout from your life insurance is tax free. The last thing you want is for most of your hard-earned money to go to the taxman instead of your loved ones. There are a couple of ways that you can do this, while remaining on the right side of the law.

How can I avoid paying inheritance tax on my life insurance?

You can do this by taking out a policy ‘in trust’. This means that rather than the payout being paid as part of your legal estate, it goes straight into a trust intended for a specific beneficiary or group of beneficiaries such as your children. The trust is cared for by a trustee, who is normally a relative or a solicitor, until the money is paid to the beneficiary. If your beneficiary is your child, then you can set this to be a date when they turn a certain age, like 18 or 21. At the moment, it’s suggested that only 6% of customers write their life policies in trust - there’s no doubt that many more people could be benefiting greatly from doing so.
Another benefit of putting a life insurance policy into trust is that the payout is often a lot quicker than it otherwise would be. This is because the beneficiaries don’t have to wait until probate is granted before receiving the money. Probate is the legal process where an executor is granted the permission to deal with the assets of a deceased person. This can often be a very long process, even more so if the deceased party hasn’t arranged a will. As well as being quicker, the process of having your life insurance policy written in trust can be more streamlined, as it cuts out a lot of the paperwork.
You could also pay less inheritance tax by taking out a ‘whole of life’ insurance policy, instead of a term life insurance policy. This sort of policy is normally used to reduce inheritance tax. Under this policy type, any payout should cover an inheritance tax bill.
Things to Bear in Mind…
If writing life insurance policies in trust to avoid inheritance tax was always the best choice, then much more than 6% of customers would be doing it. There are other factors you need to think about, so that you can make a fully informed decision.
While you might avoid having to navigate inheritance tax forms, trusts in themselves are still legally complicated and come with their own jargon and concepts that you’ll need to get to grips with. Also, once a policy has been put into trust, you don’t have any control. Sure, you can choose the terms of the trust, like who is paid what amount under which conditions. But once transferred to your trustee, it’s unlikely that these terms can be changed, and it’s almost certain than the process can’t be cancelled. A policyholder should always look carefully at the particular trust that they’re using.
So, it’s important that you get the right advice on taxes and law. This will make sure that the terms of your trust are clear, so that you can provide your loved ones with the best possible protection after you’re gone.

How can I calculate my inheritance tax?

If you think your family will owe inheritance tax on your estate when you pass away, it’s important to work out the size of this bill when taking out life insurance. Your life insurance payout will probably go towards paying off debts, funeral expenses and helping your family get through bereavement. Therefore, your payout may not be enough if they find themselves lumped with a large inheritance tax bill.
Calculate what your estate is worth and see if you will need to pay tax. The average property price outside of London is about half of the tax threshold. So, if you own your property outright, your other assets could easily place you in the inheritance tax bracket. Rising house prices combined with other things like your savings, investments and even your family heirlooms can quickly stack up.
It’s also worth considering that if you give any gifts away whilst alive, they may still be due tax when you die if you give them away within seven years before you die. So, you won’t necessarily be avoiding tax if you give away some of your assets before you die.

Can life insurance be used to pay tax on my estate?

If you plan ahead, then you could have your life insurance payout help pay off the tax bill on your estate after you die. If the value of your estate is above the inheritance tax threshold, then your family will have to pay tax on this amount. If your life insurance is in trust, it is exempt from tax so it can be used to cover the tax bill on your estate.
If your financial situation is quite complicated, it’s best that you speak to an independent financial adviser to find a solution that works for your taxes and estate.

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Fergus Cole

Author: Fergus Cole

Fergus is a journalist specialising in the personal finance, energy and broadband sectors. He also has a passion for travel and adventure so tries to make the most of this in any spare time he gets.

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