How does life insurance taxation work?

Life insurance policies provide a financial safety net for loved ones after your death. Payouts are usually a lump sum, but some policies offer regular income to help with living costs.

When investing in life insurance, it's worth considering what your family will need. You might want to cover funeral costs, everyday living costs, or pay off the mortgage so your loved ones can stay in the family home.

Most people buy life insurance policies to support their dependents when they're gone. When you buy a policy, you complete paperwork confirming who should receive your life insurance payout. You might nominate your spouse or partner. You can also nominate your children, but they'll only receive the payment if they're over 18 when you die.

You can nominate anyone you choose. However, if you want to support an elderly or vulnerable relative, it's worth seeking professional advice. A life insurance payout can affect eligibility for means-tested benefits or a care plan, leaving them worse off.

Most people pay for life insurance policies with their net income after tax. Life insurance premiums are only tax-deductible if you run a business and have invested in group life insurance to provide death-in-service payments as an employee benefit.

A life insurance payout isn't subject to income tax or capital gains tax. However, it may be subject to inheritance tax, depending on your circumstances and the policy's structure.

As we've mentioned, most life insurance policies are only taxable if they're subject to inheritance tax. However, tax-free life insurance is still possible. Your inheritance tax liability depends on the overall value of your estate and whether it exceeds the inheritance tax threshold. If you think your life insurance payout could take your estate's value over the threshold, you can structure the policy to ensure your beneficiaries don't have to pay tax on the lump sum they receive.

Let's consider the inheritance tax rules in more detail.

If you've made a will and appointed executors, they must follow the probate process and the provisions set out in your will to distribute your assets. If you don't have a will, someone must volunteer to distribute your estate assets according to the intestacy rules.

As part of probate, your representative values your estate and reports to HMRC to ensure you pay the correct amount of inheritance tax. There's an inheritance tax threshold, which gives you a tax-free allowance. Your executors must pay 40% tax on the value of anything above that, which comes out of your assets. If you don't own a home or have minimal assets, your life insurance lump sum may not take your estate above your tax-free allowance. However, this is unlikely to be the case for most people.

Inheritance tax threshold

The current inheritance tax threshold is £325,000 per person, which is fixed until 2028. If you're married or in a civil partnership, you can also transfer any unused allowance to your partner if you don't use it when you die.

Other tax allowances also apply, so it's worth speaking to a legal professional to ensure you make the most of these when planning your estate and writing a will. Any other assets that take the value of your estate over £325,000 are taxable at 40%.

Residence nil rate band

If you own a home and leave it to your spouse, civil partner, children or another direct descendant, you can claim the residence nil rate band on top of your tax-free inheritance tax threshold. The residence nil-rate band adds a further £175,000, bringing your total allowance to £500,000 per person. It's also transferable to your spouse or civil partner, meaning you can leave joint assets of up to £1 million.

The benefit tapers once your estate reaches £2 million. The residence nil rate band only applies if you leave your home to your partner or a direct descendant, such as a child or grandchild. You can't claim it if you leave your house to a sibling or other relative.

A Trust acts as a wrapper that protects your life insurance from inheritance tax. It means your loved ones can receive the payment without having to pay tax. When life insurance policies pay into a Trust, it means they don't form part of your estate and aren't subject to inheritance tax.

Using a life insurance Trust can provide quicker access to funds because the payout is not subject to the probate process. This allows beneficiaries to receive the money faster, helping them cover immediate expenses and avoid financial stress during a difficult time.

What is a Trust?

A Trust is an arrangement that means you don't have legal control over your life insurance money, as the Trust owns it instead. Your legal adviser will create a Trust document appointing Trustees (ideally more than one) to manage the Trust for you. When you die, the Trustees must send the life insurance payment to your chosen beneficiaries.

If you want to leave money to children, the Trust document explains what happens if you die before they reach adulthood. Trusts have strict rules, so seek legal advice to follow proper procedures.

How trusts affect tax

When life insurance pays into a Trust, the Trust becomes the owner, so the proceeds do not form part of your estate. If your assets are below the inheritance tax threshold, beneficiaries won’t pay any inheritance tax; otherwise, it can reduce the tax bill.

How to create a trust

Most insurers will offer to create a Trust on your behalf when you buy a life insurance policy. Creating a Trust when you buy the policy is often the most straightforward and cost-effective method. If you decide to put your life insurance policy into a Trust later, you'll usually need to pay a solicitor or financial adviser. In contrast, your insurer will do it at no charge. Getting professional advice is always a good idea, as once your life insurance is in a Trust, you usually can't take it out again.

Choose your beneficiaries

Choosing your beneficiaries will likely be easy if you want to leave money to your spouse, partner or your children. You may want your Trustees to be able to use the funds to support your children before they reach 18, or a vulnerable person who receives benefits or has a care plan in place. In that case, you may need a separate Trust, so your Trustees can manage the money on their behalf. Always seek legal advice to ensure you have the proper provisions in place.

Find the right trustees

Your trustees will manage the Trust for you and send your life insurance payment to your loved ones when you die. Depending on the instructions you give them, they might also manage your children's or other vulnerable beneficiaries' funds in the long term. Trusts have to be registered with HMRC, and there are rules and reporting procedures to follow. Your trustees must be able to meet the requirements. There are potential personal liabilities if they don't follow the rules and cause a loss, so it's a big responsibility. Other trustees can have them removed, or your family can apply to the Court after you're gone, which isn't ideal when they're grieving.

Trustees must be over 18. They can't act if they have a criminal record or have ever declared bankruptcy.

Create a life insurance deed

We've mentioned the document that creates a Trust. It's called a trust deed, and it's a legally binding document. The document sets out the beneficiaries, trustees and the Trust terms. For example, you can specify that your children will receive a lump sum upon reaching a certain age. It also confirms your trustees' duties so they understand what they need to do upon your death.

When your insurer, financial adviser or solicitor has finalised the Trust deed, you sign it to confirm it matches your instructions. It's legally binding from that point.

Get in touch

Investing in the right life insurance gives you peace of mind, knowing your family has a financial safety net if the worst happens. Speak to us for specialist advice, to help you find the life insurance policy that’s tailored to your needs.