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Life insurance tax options: is life insurance taxable?

Will my life insurance payout be taxed?

When you take out a policy with life cover you will be pleased to think that your loved ones are going to benefit from a lump sum if you die during the term of the policy. Yet, might you have some doubts about whether or not life insurance tax could end up reducing the amount that they receive. We’ll explain all the possible tax liabilities for you right here.

If any tax has to be paid at all on a life policy payout, it will be in the form of inheritance tax, which is currently set at 40% of everything you leave behind above £325,000. It is possible that, even after the insurance payout, your estate won’t rise above this amount and therefore no tax will be due. Anything left to a spouse or civil partner is free of inheritance tax, and, it is also possible to write your policy in trust to sidestep inheritance tax if leaving your money elsewhere.

We’ll take you through everything below, but first let’s run through the different UK taxes to find out why they do and don’t apply to life protection policies.

Does income tax get paid on life insurance?

No. Receiving a payout from a life cover policy does not count towards your income, just like with anything else that is inherited through the will of a deceased friend or relative. So there will be no life insurance tax due when the payout is made.

What about capital gains tax?

Again, no. Capital gains tax in the UK is the tax payable on the profit made when you sell an asset. As life protection is not an asset, there’s no need to worry about capital gains tax.

So what amount of inheritance tax will I have to pay?

As outlined above, UK inheritance tax is currently set at £325,000 tax-free threshold, above which everything is taxed at 40%. Life cover payouts count as part of your estate and so can contribute to pushing you over this limit. It is important to note that there is no inheritance tax due on anything left to a spouse or civil partner, so if they are the beneficiary of your policy then there’s nothing to worry about.

When figuring our what you might owe, the value of your estate is the combined value of everything you own minus debts that need to be paid off. So, for example, if you are insured for £150,000 and the combined value of your estate was already £400,000, that would raise the overall value to £550,000. Inheritance tax would then be owed on 40% of £225,000 (£550,000 - £325,000), meaning an overall inheritance tax bill of £90,000.

That’s a fair bit of money, so to lower any tax liability and make sure your loved ones get a larger financial windfall, it can therefore be a good idea to write your life policy in trust.

How does writing life cover in trust save on life insurance tax?

Writing your life cover in trust is a way of keeping the payout separate from your estate and therefore preventing it contributing to any inheritance tax that may be due. A trust is a legal agreement with named trustees who have legal ownership of the trust and act on behalf of the beneficiaries.

If we look again at our previous example, writing your £150,000 life cover in trust would remove it from your estate, which would remain at its value of £400,000. This would mean 40% inheritance tax would only be due on £75,000 (£400,000 - £325,000), making a total tax bill of £30,000. The beneficiaries of the policy would therefore get the whole £150,000 policy paid to them tax-free and save £60,000 in inheritance tax at the same time.

You can put your life policy in trust at any time, and there are a few different options to consider if taking this route. All the details are explained on our page that takes you through writing life policy in trust.