Income and capital gains tax
Legal & General explains that life insurance payouts are not normally taxable, so your beneficiaries will not pay income or capital gains tax on the money. However, any interest earned between the date of death and the date the payout is made could be subject to income or capital gains tax.
Inheritance tax
The bigger issue is inheritance tax. Life insurance proceeds usually count as part of your estate. If your estate exceeds the nil‑rate band (currently £325,000 per person), the portion above the threshold may be taxed at 40%. A life insurance payout could push your estate over this threshold, leaving less money for your beneficiaries.
Using a trust
Putting your life insurance policy in trust can keep the payout outside your estate. Both Aviva and LV= explain that when a policy is written in trust, the proceeds do not form part of your estate and therefore are not subject to inheritance tax. This means your loved ones receive the full benefit without waiting for probate. Trusts also let you specify who should receive the money and in what shares.
Inheritance tax thresholds and exemptions
Life insurance payouts are only exposed to inheritance tax when they push the total value of your estate above the government’s nil‑rate band. Lloyds Bank notes that the current threshold is £325,000 per person, with any amount over that taxed at 40%. Anything you leave to a spouse, civil partner or charity is exempt from IHT. If you leave your home to your children or grandchildren, your IHT allowance can rise by an additional £175,000, increasing your threshold to £500,000. Couples can combine their allowances, potentially creating a tax‑free threshold of up to £650,000, and with the Residence Nil Rate Band, the tax‑free allowance could be as high as £1 million.
Because your life insurance payout counts as part of your estate unless it is written in trust, it may push your estate value above the nil‑rate band. Assess the potential value of your estate – including property, savings, investments and insurance policies – and consider whether using a trust or gifting assets during your lifetime could reduce future IHT liabilities.
Key points
- Payouts are usually tax‑free. Beneficiaries generally pay no income or capital gains tax on life insurance proceeds.
- Interest may be taxed. Any interest accrued before the payout is made could be taxable.
- Inheritance tax may apply. If the payout forms part of your estate and the total estate exceeds the IHT threshold, 40% tax is due on the excess.
- Write your policy in trust. Writing the policy in trust usually removes the payout from your estate and avoids inheritance tax.
It’s wise to speak to a financial adviser about trusts and estate planning to ensure your life insurance achieves what you intend. Remember that UK tax rules can change and depend on individual circumstances.
Are life insurance premiums tax‑deductible?
For personal policies, life insurance premiums are not tax‑deductible. Legal & General explains that premiums you pay are not considered an allowable expense by HMRC. In other words, you cannot offset the cost of your life insurance against your income tax bill, and there is no tax relief available on personal life insurance.
Premiums, trusts and tax relief
While premiums are not tax‑deductible, putting your policy in trust can bring inheritance tax advantages. When a policy is held in trust, premiums are treated as a series of gifts and are typically exempt from inheritance tax because they are regular gifts from income or fall within the annual gift allowance. This doesn’t reduce your income tax, but it may prevent the payout from being taxed as part of your estate.
Review your arrangements regularly: for example, if your policy is written in trust and premiums are funded from joint accounts, make sure the trust documentation reflects who is making the gifts. A financial adviser or solicitor can help set up the right type of trust and ensure you comply with HMRC rules.
