People use life insurance to make sure their families or dependents will receive cash benefits if they are no longer there.
Are life insurance benefits taxable?
When money is paid as part of a life insurance policy in the UK, the payout is not taxed, meaning the person or persons receiving the payment should not automatically pay tax on the money. However, although generally exempt from income tax, some life insurance benefits may still be subject to inheritance tax.
Life insurance and tax implications
Since life insurance benefits are considered part of your estate, which is subject to inheritance tax (IHT), your loved ones, the beneficiaries of your life insurance, might have to pay tax on the inheritance they received from you, including its life insurance portion. This inheritance tax depends on your financial situation at the time of your death and the size of your life insurance policy payout.
If you want to leave an inheritance for your family, chances are you will also want them to suffer from as little tax as possible on the inheritance you are passing on.
Tax numbers are always subject to change, but at the time of writing, if you are single, the current threshold for inheritance tax in the UK is £325,000, meaning that, if the total value of your possessions at the time of your death exceeds £325,000, any amount over £325,000 will be taxed at 40%. If you are married or in a civil partnership at the time of your death, each part of the couple has their own inheritance allowance of £325,000, meaning the couple will benefit from a total inheritance tax-free allowance of £650,000 and will only have to pay 40% tax on anything above that level.
If your life insurance payout was to take the total value your estate to a level in excess of the above threshold relevant to your situation, and unless the money is going to a charity, that excess value will be taxed at 40%.
Trusts for life insurance
However, there is an easy way that families in the UK can legally use to avoid having to incur inheritance tax liabilities on their life insurance payouts. To achieve this, they simply put their life insurance policies into a trust. If a life insurance payout is "in trust", it is considered separate from your estate and thus not likely to be subject to any inheritance taxes.
Trust means that someone else, be it your lawyer, family member or other trustee of your choice, is in control of the life insurance payout distribution from a legal perspective. This takes life insurance payout outside of your estate and thus outside of your tax liabilities. At the same time, you can still have the trustee follow your wishes when handling your life insurance payout. So the funds will be paid out the same way as you wish, probably even faster as the payment will not have to go through the estate inheritance tax and legal procedures.
When you talk to one of our FCA-authorised life insurance advisers, you can ask if you can buy your insurance policy in trust, they can certainly help and guide you how you can set it up.
Benefits of life insurance in dealing with tax liabilities
If a family's wealth likely to be transferred as inheritance is of a size exceeding the above thresholds (which would be the case for most property owners in the UK given the rise in average property prices over the last several decades), one of the important benefits of life insurance and putting it into a trust can be the support it provides to families who have to pay their tax bills on the inheritance received.
As life insurance payouts from trusts are exempt from inheritance tax, families can use life insurance as a very cost-effective and efficient mechanism to meet their tax liabilities on the estate that will arise on a family member's passing. Thus, senior family members can quite affordably help their loved ones to avoid having to sell off their inherited property or other possessions in order to meet the demands of the taxman they would have to deal with.
If you believe your family is likely to have to pay inheritance tax on your estate after your passing, it might be worthwhile to look into setting up a life insurance plan and calculate the amount of this tax before purchasing it. This will help you make sure your life insurance payout is at least sufficient to cover the potential tax liabilities for your loved ones and if you'd like to leave more than the taxman's share then go for some extra help for your family as your future policy payout.
Before taking any practical steps, it is always recommended to consult your own financial adviser who will be able to look into your specific situation and assist in making those decisions. Our FCA-authorised and award-winning insurance experts can guide you in a friendly and free phone consultation as to what life insurance plans can be most suitable to your particular circumstances and life planning.
It takes less than 30 seconds to set up a free phone consultation with them to check how different plans from various insurance companies compare against each other and fit you best – just fill in a quick quote form on the button below and get a free, no-obligation quote from FCA-authorised life insurance experts!