Taxation of life insurance

Hello there! I am Gemma, a legal assistant at Lawyer Destroyer. I would be happy to explain how life insurance is taxed here in the UK.

The short answer is that life insurance payouts are usually completely free from Income Tax and Capital Gains Tax. However, they can sometimes be hit by Inheritance Tax, depending entirely on how the policy is set up.

Here is a simple breakdown of how the different taxes apply.

Income Tax and Capital Gains Tax
When a standard life insurance policy pays out after someone passes away, the lump sum is not treated as income or a capital gain. This means the people receiving the money will not have to pay Income Tax or Capital Gains Tax on the payout itself.

Inheritance Tax
This is the main tax you need to watch out for.

If your life insurance policy is simply set up in your own name, the payout will normally go straight into your legal estate when you die. Your estate is the total value of everything you own, including your property, savings, and investments.

In the UK, if the total value of your estate goes over the Inheritance Tax threshold, which is currently 325,000 pounds, anything above that amount usually faces a 40 per cent tax charge. Because life insurance payouts can be quite large, adding that money into your estate can easily push it over the threshold, leaving your loved ones with a hefty tax bill.

There is a major exception to this. If your entire estate, including the life insurance payout, goes directly to your husband, wife, or civil partner, there is usually no Inheritance Tax to pay at all.

A Practical Fix: Writing the Policy in Trust
If you want to make sure your life insurance payout goes directly to your loved ones without being swallowed up by Inheritance Tax, the most sensible practical step is to write the policy in trust.

When you put a life insurance policy in trust, it essentially separates the policy from your legal estate. When you pass away, the money is paid directly to the people managing the trust, who then pass it straight on to your beneficiaries.

Doing this has two massive practical benefits. First, the payout does not count towards your estate, meaning it is completely safe from Inheritance Tax. Second, because the money is kept outside of your estate, your family will not have to wait for the often lengthy probate process to finish before they can actually access the funds.

Most insurance providers offer the option to write a policy in trust completely free of charge. If you already have a policy and it is not currently in trust, or you are simply not sure, it is usually quite straightforward to contact your provider and ask them to set up a trust form for you.

I hope this makes things a bit clearer! Please let me know if you have a specific type of policy in mind or if you need help with anything else.