Life Insurance and Inheritance Tax at a Glance

What Are The UK Tax Rules For Life Insurance?

Life insurance protection is one way to ensure that your family or dependents are financially secure when you are no longer around. Any person you name on your life insurance is considered a beneficiary, and they may have to pay tax on any money that they receive.

This could come as a surprise to anyone who knows that insurance payouts are not taxable in the UK. It’s true that the payout itself is tax-free, so beneficiaries don’t automatically have to pay tax on it. However, in certain circumstances, tax obligations do apply.

Life insurance can be considered part of your estate, and if your estate exceeds a certain amount, inheritance tax applies. There is a legal threshold beyond which your beneficiaries will be expected to pay inheritance tax on your estate.

Do You Have To Pay Inheritance Tax On Life Insurance?

Usually, the payout from a life insurance policy forms part of your legal estate. Right now, the threshold for an estate is £325,000: if your estate exceeds this, then the surplus will be liable to inheritance tax. The current rate of inheritance tax in the UK is 40%, quite a considerable sum!

There are ways to avoid your beneficiaries being charged on your life insurance payout. This is a desirable outcome because you naturally want your loved ones to have as much financial security as possible when you’re no longer around.

Putting your life insurance policy in trust is a simple and legal way to dodge inheritance tax being charged on your life insurance payout. This is a legal agreement appointing certain trustees to look after the policy on your beneficiaries’ behalf until they’re meant to benefit from it.

How does this work? Well, the payout will eventually go straight to your beneficiaries. It won’t become part of your legal state, so there will not be subject to inheritance tax.

Does Life Insurance Form Part Of Your Estate After Death?

Your estate is subject to inheritance tax once it exceeds the threshold of £325,000. It is formed by the money, pensions, investments, assets, and property in your possession at the moment of your death. The only money that’s excluded is what’s used to pay any outstanding debts and your funeral expenses. Life insurance is often taken out so that families can pay these costs.

The payout of your life insurance policy will usually be added to the value of your estate. This is very important if it’s going to take your estate over the inheritance tax threshold. Anything over the amount of £325,000 will be subject to 40% inheritance tax.

In this situation, although life insurance payout itself is tax-free, it will ultimately be subject to tax as part of your estate.

How Is Life Insurance Classified?

In the UK, there are different kinds of life insurance:

  • Whole-of-life cover, which guarantees a payout for your dependants no matter when you die. This is in contrast to other kinds of cover which only payout if you die before a specific date.
  • Term insurance, which pays out only if you die within a specified time period. This can be useful if you want to cover mortgage payments for your loved ones, for example. Once the mortgage is paid, it’s no longer necessary.
  • Decreasing-term insurance, meaning that the potential payout reduces over an agreed period. Again, in the context of paying off a mortgage, this could reflect the way that mortgage debts decrease over time.
  • Increasing-term insurance, which has the opposite effect. If you want the potential payout to increase to reflect inflation, this would be a smart choice. Index-linked policies are directly connected to inflation rates.
  • Renewable term insurance, which can be extended at the end of a fixed period.
  • Joint life insurance, for couples that want to arrange a payout in the event of one person dying. This can be cheaper than two separate policies.
  • Death-in-service benefits, offered by a company if an employee dies while in the firm’s employment.

The Benefits Of Putting Life Insurance Into A Trust

Beyond avoiding inheritance tax, there are other benefits of putting your life insurance policy into trust. It empowers you to decide your trustees and who will receive the payout from your life insurance. This is especially important if you’re not married or part of a civil partnership.

It also ensures that the payout will be given to your preferred beneficiary much quicker. It won’t be included in the probate process. Setting up a trust doesn’t need to cost anything and it’s relatively easy to do, too.


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