Life insurance and tax

Life insurance can help financially support the people that matter to you if you’re no longer around. However, it’s also important to understand how life insurance fits into your estate and whether it could be subject to inheritance tax after you pass away.

Read on to learn more about when life insurance is taxable and how it all works.

  • There isn’t a direct tax on life insurance. However, there’s a chance that inheritance tax might apply to your estate if something were to happen to you. This could include the value of your life insurance policy.

    Life insurance can give your loved ones the ability to claim for a financial payout if you unexpectedly pass away during the term of your policy. This lump sum could help your family or partner cover things such as:

    • Mortgage payments.
    • Childcare.
    • Everyday living costs.

    If your life insurance policy forms part of your estate, your beneficiaries may have to pay tax according to the inheritance tax allowance set by the government. If the total value of your estate is above this threshold, it could eat into the money you planned to leave for your loved ones.

    There are ways of arranging your money to protect parts of your estate from inheritance tax. Depending on the potential value of your estate, you might want to consider putting life insurance into a trust. This passes control of your life insurance into the hands of another person.

    Legally, the trust will no longer be part of your estate and could be exempt from inheritance tax. This way, your loved ones may need to pay less tax and will keep more of your life insurance payout.

    What is an estate?

    When someone dies, everything they leave behind is known as their ‘estate’. This can include:

    • Assets and possessions, such as property, money and investments, vehicles, pets and other valuable items.
    • Liabilities, such as mortgage, credit card and loan balances.

    If your estate is valued above the threshold set by the government, you may have to pay inheritance tax on it.

    What is inheritance tax?

    At present, the threshold for inheritance tax is £325,000. If your estate is valued above that, the amount of your estate above the threshold may be subject to the standard rate of inheritance tax of 40%.

    Exceptions do apply. For example, inheritance tax may not apply to:

    • Estates valued below £325,000.
    • Anything above £325,000 that is left to a civil partner, spouse, or charity.

    If you plan to leave your home to your children or grandchildren, the threshold increases further to £500,000.

  • While there is no direct tax on life insurance cover, inheritance tax applies if the total value of your estate is above the current threshold of £325,000. Your estate is made up of different assets, including:

    • Property.
    • Bank accounts.
    • Personal possessions, such as household contents, cars and jewellery.
    • Life insurance policies.
    • Pensions.
    • Bonds.

    It’s worth remembering that any borrowed money from loans and credit cards is deducted from the total value. If the value of your estate is above the tax-free limit, you may want to consider putting your life insurance policy in trust.

    Other forms of insurance

    While a life insurance payout will go to your loved ones after your passing, other forms of insurance pay out during your lifetime. These could include critical illness cover or income protection . Critical illness cover pays a lump sum if you are diagnosed with a condition listed on your policy, while income protection gives you a regular monthly payment if you’re unable to work because of illness or injury.

    You usually won’t have to pay inheritance tax in this situation as you’ll still be alive when receiving the lump sum. However, if the payout becomes part of your estate or is received by your loved ones when you’re not there, then it may be subject to tax.

  • There are some cases where parts of a person’s estate don’t contribute to their £325,000 tax-free allowance.

    Putting a life insurance policy into trust

    It’s possible to put assets such as life insurance policies into trust. This means nominating someone to take on legal control of the policy while you’re still alive.
    Most importantly, anything in a trust will be viewed separately from your estate. This means it won’t be subject to inheritance tax. Your family may even be able to claim and receive a payout faster.

    Couples and inheritance tax

    If you leave your primary home to your spouse or civil partner, it won’t be considered part of your inheritance tax allowance. While there’s no replacing your partner, it’s useful to know that married people get twice the inheritance tax allowance if one of you passes away.

    That’s up to £650,000 tax-free. This threshold may be higher if you’re planning to leave you home to children or grandchildren.

    As a married couple, you could have a tax-free allowance of up to £1 million. This includes the combined inheritance tax threshold and Residence Nil Rate Band (RNRB) for both partners.

    Inheritance tax and gifts

    Giving financial gifts to loved ones up to a value of £3,000 each year won’t incur any inheritance tax. With that said, any gifts given within seven years of your passing may still count as part of your estate. So, they’ll need to be declared to the tax authorities.

  • Here are three examples of how life insurance and inheritance tax could work:

    Example 1

    • A person’s estate – including their home, cars, money and other possessions – comes to £400,000.
    • They have a life insurance policy worth £100,000.
    • On their death, the total value of £500,000 exceeds the £325,000 threshold by £175,000. This excess is taxed at the standard rate of 40% (£70,000).

    In this example, the person’s loved ones would be left with £430,000 from their estate.

    Example 2

    • A person’s estate is worth £500,000 but £250,000 of this is the value of their home.
    • They leave the house to their children, which leaves other assets worth £250,000.

    Here, the total estate would be below the threshold of £325,000, so the person’s loved ones wouldn’t need to pay inheritance tax.

    Example 3

    • A person leaves their entire estate to their spouse or civil partner.

    In this case, there wouldn’t be any inheritance tax payable, even if the estate is above the threshold of £325,000.

An image of a couple holding hands.

Frequently asked questions

  • No life insurance policies are exempt from tax, but there are occasions where the payout from life insurance cover won’t be subject to inheritance tax. Firstly, if the total value of your estate including any life insurance policies falls below the £325,000 threshold, no tax is payable. Secondly, putting your life insurance cover in trust means it won’t be counted as part of your estate. This can help to increase the chance that the total value of your assets stays under the tax-free limit.

  • If you leave your estate to your spouse or civil partner, or vice versa, there usually won’t be any inheritance tax to pay. Also, if the first partner to pass away doesn’t use up all their £325,000 threshold, any remainder can be transferred over to the surviving partner.

  • Once a valid life insurance claim is made and approved, the beneficiaries will receive the payout. The executor of the deceased’s Will needs to be aware of this, as it’s up to them to declare and pay any due taxes. They’ll also oversee fair distribution of estate assets.

    If the life insurance policy is in trust, the payout will be made to the trustees. In this case, it’s their responsibility to distribute the funds to all named beneficiaries.

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