How does life insurance taxation work?

When you take out a life insurance policy, you pay to provide for your loved ones after you're gone. Life insurance policies pay a lump sum to your chosen beneficiaries when you die, which they can spend however they choose.

You might have taken out a policy to cover your funeral expenses, but your life insurance policy can also give your family financial security. If illness or injury shortens your life, your life insurance policy can give your spouse, partner or children the funds to keep paying the bills and stay in the family home, even when you're not around to support them.

Most people take out life insurance to ensure their loved ones and dependents receive a payout after they're gone. Many people nominate their spouse or partner to receive the money. You can also nominate your children. However, they can only receive a direct payment if they're over 18 when you die.

You can choose to nominate anyone to receive your life insurance payout. If you have dependents other than a spouse or child, you can nominate them. However, you should seek professional advice if the person you select has a care plan in place or is receiving certain benefits, as it could impact their eligibility and leave them worse off in the long term.

When you take out a life insurance policy, you pay premiums from money you've already earned and paid income tax on. Your life insurance premiums aren't tax deductible unless you run a business and have taken out a group life insurance policy to provide death-in-service benefits to your employees.

Your beneficiaries won't have to pay tax on their payment unless it's subject to inheritance tax. The payout isn't subject to income or capital gains tax but is still taxable in some circumstances.

A life insurance payout can be taxable if it's subject to inheritance tax. You can structure your life insurance policy to ensure your loved ones won't have to pay tax on the money received. Tax-free life insurance is achievable depending on your circumstances, the value of your estate and how your life insurance policy is structured.

First, let's look at the rules on inheritance tax.

After your death, your executors must take steps to distribute your estate according to the provisions in your will. If you haven't left a will, the intestacy rules will apply, and someone will need to put themselves forward to finalise your estate.

An executor must value your estate and ensure your debts, including any inheritance tax, are paid. Inheritance tax includes tax-free allowances like other taxes, so your final inheritance tax bill will take that into account. Inheritance tax is paid at 40% of anything over your personal allowances. If your assets are worth less than the threshold, there won't be any tax to pay.

If you don't own a home or have minimal assets, your life insurance payout may come under the threshold. However, this won't typically be the case.

Inheritance tax threshold

The main inheritance tax allowance is £325,000 per person. If you're married or in a civil partnership and don't use your total allowance when you die, your partner can add your unused allowance to their own.

Any assets that form part of your estate and take its total value to over £325,000 are liable for tax at 40%.

Residence nil rate band

The residence nil rate band gives you an additional inheritance tax allowance if you own a home and leave it to your spouse, civil partner or children. It adds an extra £175,000 to your allowance, taking the total to £500,000 per person. Again, your spouse or civil partner can use your unused allowance, meaning you can leave joint assets of up to £1million.

The residence nil rate band doesn't apply if you leave your home to another relative, such as a sibling, niece or nephew. However, you can still use it if your house goes to another direct descendant, such as a grandchild.

When you create a trust, you give your family a tax-free life insurance payment. A Trust creates a wrapper that means any life insurance money doesn't form part of your estate for tax purposes. If your assets are already at or near the threshold, your heirs won't have to pay taxes on their payout.

Creating a trust can also mean that your loved ones get their money more quickly. The probate process can be lengthy as executors must identify all your assets and comply with their legal duties before finalising any inheritance. Life insurance paid out of a trust can be with them quickly. If your death was sudden or unexpected, that could be a real lifeline at a stressful time.

What is a Trust?

A Trust is a legal arrangement that locks your life insurance policy away so you're no longer the legal owner. The trust takes on ownership of your life insurance instead. You'll appoint a trustee (or more than one) to manage the trust for you. Then, when you die, your policy pays the life insurance proceeds into the trust. The trustees have a legal duty to ensure that the life insurance payment goes to your chosen recipients according to your wishes.

If you decide to leave some money for your children, you'll also need to determine what happens if you die before they reach adulthood. You can create trusts and nominate trustees in your will to achieve this. It's wise to get professional advice on this as there are strict rules on the administration of trusts and trustees' duties.

How trusts affect tax

When you create a Trust with your life insurance policy, the trust takes on the legal ownership of the policy and receives the money when you die. For tax purposes, your life insurance payout doesn't become part of your estate or count towards the total value. If the rest of your estate falls within your existing tax allowances, you won't have to pay tax at all. If your other assets exceed the threshold, it'll reduce your tax bill.

How to create a trust

Organising trusts for life insurance policies is usually straightforward. Most insurance providers offer this service at no extra charge as a standard part of setting up your policy. You don't have to create the trust when you first take out the policy, but if you decide to do it later, you may need to pay a financial adviser or solicitor to help you. Once you've created the trust, you won't usually be able to change your mind.

Here are the steps you can expect to go through to create a trust.

Choose your beneficiaries

In theory, this part of the process should be simple. You'd likely only take out a life insurance policy if you have someone you want to benefit. You could nominate your spouse or partner, or you could choose to leave money for your children or another dependent. If you want your life insurance payment to go to your children before they reach 18 or a dependent classed as a vulnerable person, you'll likely need an additional trust. You'll need to take separate advice from a solicitor or will writer.

Find the right trustees

Trusts are managed by trustees, who you'll need to appoint when you create the trust. Your trustees will need to understand their legal duties, deal with the trust paperwork and transfer the money in accordance with your wishes. Trustees can be personally liable if their actions cause a loss, so it's vital you choose people who can cope with the responsibility. If they don't, the other trustees can apply to have them removed, so it's a good idea to have more than one in case this happens. Your family can also apply to the Court, which would cause additional worry at an already stressful time.

Other than that, anyone over 18 can be a trustee if they don't have a criminal record and haven't been declared bankrupt.

Create a life insurance deed

A life insurance policy is put in trust using a trust deed. The deed is a legally binding document that identifies you and names your trustees and beneficiaries. It also states the terms of the trust, for example, when it will pay out and what the trustees' duties are.

The deed document ensures that your wishes are clear so the trustees know what to do upon your death. When the deed's ready, you'll sign it to confirm that you're happy with the contents and to make it legally binding.

Get in touch

Choosing the right life insurance policy gives you peace of mind, knowing your family is protected should the worst happen. We're specialist brokers who can advise you on an appropriate policy tailored to your needs.

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