Understanding life insurance and tax

Life cover can be a reassurance to you and your loved ones, providing them with financial support when you’re not there anymore. However, it’s important to be aware that your life insurance policy could form part of the estate you leave behind. This means it may be subject to inheritance tax after you pass away.

This guide explains what taxes could apply to a life insurance payout.

  • Providing your beneficiaries make a successful claim, life insurance could provide them with a lump sum should you die unexpectedly. This money could be used to cover things like mortgage repayments, childcare or everyday living costs.

    Although there’s no direct tax on life insurance, inheritance tax could apply to all assets that form part of the estate you leave behind. And that could include any potential life insurance payout.

    In that situation, your life insurance payout would be subject to the inheritance tax allowance set by the government. Anything above this threshold may be subject to inheritance tax, potentially eating into the payout intended to support your loved ones in your absence.

    Depending on the potential value of your estate, you might like to consider holding some of your assets in a trust, including your life insurance policies.

    Control of a trust can be transferred from you to another person in the event of your passing. Legally, the trust will be viewed as separate from your estate, so would be exempt from inheritance tax. That could mean your loved ones will pay less tax and receive more of your life insurance payout to support them into the future.

    What is an estate?

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

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

    Inheritance tax may be payable when an estate is valued over a certain threshold, set by the government.

    What is inheritance tax?

    The current threshold for inheritance tax is £325,000. If your estate is valued above that, anything over that figure may be subject to the standard rate of inheritance tax of 40%.

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

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

    The threshold for inheritance tax can also increase to £500,000 if you leave your home to your children or grandchildren.

    It’s worth knowing that inheritance tax can also apply to gifts made by the deceased in their lifetime, subject to tax exemptions and relief.

    It is the responsibility of the estate administrator or executor to figure out and pay the right amount of inheritance tax. If there’s a life insurance payout, this won’t be taxed at source but its value may go towards the inheritance tax threshold.

  • No, a life insurance payout is not directly taxable. However, if your life insurance policy is not written in a trust then it will form part of your estate and its value will go towards your inheritance tax threshold of £325,000.

    Working out the potential value of your estate could help you make decisions about your finances and how to protect your family. For example, you may consider transferring some of your assets into a trust, helping you to limit the future impact of inheritance tax.

    Think about the value of:

    • Your property.
    • Bank accounts.
    • Personal possessions, like your household contents, cars and jewellery.
    • Life insurance policies.
    • Pensions.
    • Bonds.

    Things like loans and credit card balances should be deducted from this value.

    Now you’ve worked out the potential value of your estate, does it exceed the inheritance tax threshold of £325,000?

    If your property is worth less than £2 million and you leave it to a child or grandchild, you’ll get an additional tax-free allowance of £175,000. This brings your threshold to £500,000.

    Anything over and above the applicable threshold may be subject to inheritance tax, at a standard rate of 40%.

    Other forms of insurance

    If you make a successful claim against another form of policy, like critical illness cover or income protection, you could receive a payout yourself. This means the money is there for you to spend on your needs, such as mortgage repayments, living costs or making alterations to your home.

    Inheritance tax won’t apply in these situations, unless the payout becomes part of an estate you eventually pass on, or if the payout is received by your beneficiaries after your death.

  • If you’re concerned that inheritance tax will eat into the benefit you’d like to leave for your loved ones, you may like to think about:

    Putting assets into a trust

    You could put assets, including life insurance policies, into a trust. In the event of your death, legal control could be passed to your beneficiaries. Most importantly, the trust will be viewed separately from your estate, so anything held within it won’t be subject to inheritance tax. Your beneficiaries may also be able to claim and receive a payout faster.

    Couples and inheritance tax

    Leaving your primary home to your spouse means its value won’t go towards your inheritance tax allowance. Married people get twice the inheritance tax allowance in the event of their spouse passing away – £650,000 in total.

    For couples who plan to leave their home to their children, or grandchildren, the inheritance tax threshold could be higher still. Accounting for the combined inheritance tax threshold and Residence Nil Rate Band (RNRB) for both partners, the tax-free allowance could be as high as £1 million.

    Inheritance tax and gifts

    It’s permitted to give financial gifts to your loved ones, of up to £3,000 each year. This could reduce your overall estate value and limit the tax due on it – or negate inheritance tax altogether. Just be aware that any gifts given within 7 years of your death could still be considered part of your estate and must be declared to tax authorities.

  • Below are 3 examples illustrating how inheritance tax could affect your estate:

    • Your estate – your home, cars, money and other possessions – comes to £400,000. You also have a life insurance policy with a value of £100,000. On your death, the total value of £500,000 exceeds your £325,000 threshold by £175,000. This excess is taxed at 40%, or £70,000. In this example, your beneficiaries would be left with £430,000.
    • Your estate is worth £500,000, but £250,000 of this is the value of your house. You leave your house to your children, leaving other assets worth £250,000. This is below the inheritance tax threshold, so no tax would be due.
    • You leave your entire estate to your spouse or civil partner. This means that no inheritance tax applies, even to anything over the £325,000 threshold.
Frequently asked questions

Frequently asked questions

  • If the value of the estate you leave behind is lower than the current inheritance tax threshold of £325,000, tax wouldn’t apply.

    If your estate may be worth more than that, accounting for things like potential life insurance payouts, you may consider placing some of your assets in a trust. This could help you and your beneficiaries to limit the future impact of inheritance tax.

  • No, an estate left to a spouse or partner is exempt from inheritance tax. This is the case regardless of the estate’s value. So, even if it’s over the inheritance tax threshold, it will still be tax-free.

  • Once a valid life insurance claim is made and approved, a payout will be made to the deceased’s beneficiaries. It’s important for the executor of the deceased’s Will to be aware of this, as it’s their responsibility to declare and pay any due taxes and ensure fair distribution of estate assets.

    If the life insurance policy is in trust, any payout will be made to the trustees. They’ll be responsible for distributing these funds to all named beneficiaries.

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