Life insurance & Tax

Work out your tax options when taking out life insurance

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Read our guide to find out how inheritance tax affects life insurance pay outs.

If you have taken out life insurance to provide a lump sum or regular income to your loved ones when you die, there is usually no income or capital gains tax to pay on the proceeds of the policy. However, the pay out could be subject to inheritance tax (IHT) at 40%.

In other words, a pay out of £100,000 would be worth just £60,000 after IHT. But you can legally sidestep IHT by writing your life policy in trust.

Types of policy

There are various types of life insurance, but term insurance is the most common and the most straightforward. Term insurance pays out a cash sum if you die within the term of the plan and is not normally subject to income or capital gains tax. It is known in tax speak as a ‘qualifying policy’.


Life insurance policy types

People take out term insurance primarily to provide financial security for their family. So, if you have young children you might take out level term insurance to pay out a lump sum of £100,000 on death within a 20-year term.

With decreasing term insurance, sometimes called mortgage life insurance, the pay out gradually decreases over the term of the policy. It is usually cheaper than level term insurance and works well with a repayment mortgage where the amount you owe reduces over time.

You can also buy something called family income benefit, which makes regular payments to your dependents instead of a lump sum if you die within the policy term.

Read: Life insurance policy types

Inheritance tax

When you die, inheritance tax at the standard rate of 40% is normally due on the value of your estate above £325,000, unless you leave everything to your spouse or civil partner. For example, if you died and your estate was worth £500,000, there could be an IHT bill of 40% of £175,000, or £70,000. Your estate is basically anything you own such as cars, money and jewellery – and the proceeds of any life insurance.

It also includes your home, but a recent change to IHT rules means that if you leave your home to your children or grandchildren, the threshold increases to £425,000.

The IHT threshold might seem high, but the average house price in the UK is £220,000. Homes are more expensive in the south east, at an average of £380,000, which is over the standard IHT threshold. It is therefore worth making sure that the pay out from your life insurance is tax free.

Policy in trust

If you put your life policy in a trust, the pay out will not be considered part of your estate and so will not be liable for IHT.

A trust is a legal arrangement that means you give your policy to the trustees who become the legal owners and look after it on behalf of the beneficiaries.

It’s relatively straightforward to set up a trust. Your insurer should be able to help and the service should be free. You can put your policy in trust at any time, though it makes sense to do it as early as possible, preferably when you first take out the cover.

There are a couple of other advantages to a trust. These include:  

  • The arrangement allows you to control who gets the money from your life insurance policy because you specify the beneficiaries.
  • It also usually leads to a speedier pay out. If the policy does not form part of your estate it does not get caught up in all sorts of lengthy legal proceedings such as probate, so the money should be paid to your beneficiaries much quicker.

You might be liable for income tax at the higher and additional rates on a life insurance pay out if your policy is non-qualifying, which usually means it includes some sort of investment element. The definition of non-qualifying is complex, but your insurer will be able to tell you whether you have a non-qualifying plan.

Tax is a tricky subject so if you have a non-qualifying policy, or if you are unsure about setting up a trust, you should talk to a specialist adviser.

Read: Life insurance and trusts

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