Understanding what life insurance is can bring about a host of questions, especially regarding taxes and how they may affect your policy’s payout. It’s essential to know the ins and outs of life insurance taxation to ensure that your loved ones receive the intended financial support without unexpected deductions.

Life insurance provides a lump sum payout upon a valid claim if you pass away within the specified term of your policy. This sum can provide financial support for your family, covering various expenses such as mortgage repayment, educational costs or even that once-in-a-lifetime holiday. There are a range of different types of life insurance to suit your family’s budget and circumstances. Some of these include whole of life, decreasing life insurance, mortgage life insurance and family income benefit, offering tailored options to support your family’s needs and lifestyle.

At The Insurance Surgery, we get asked these questions all the time, and we’re happy to help. Our friendly and experienced advisers can guide you through the process of life insurance and how best to protect your family and their payout.

We’ll guide you through the complexities of life insurance and inheritance tax and offer strategies to optimise your policy’s benefits.

Do you pay tax on life insurance?

Inherited life insurance isn’t taxable in terms of income tax. This means that you don’t have to worry about losing a portion of the payout to taxes when they receive the funds. Whether it’s a term life policy or a permanent life insurance plan, the funds received from the policy are income tax-free.

Do you pay inheritance tax on life insurance?

Life insurance and inheritance tax can be complex topics, but we’re here to simplify the terminology and provide clear explanations. In the UK, inheritance tax is charged on the estate of a deceased individual. An individual’s estate can include their property, money, and possessions. There is typically no inheritance tax if the estate’s value is below £325,000, or if everything above this threshold is left to a spouse, civil partner, charity or community sports club.

Inherited life insurance is taxable if the life insurance payout is included as part of the policyholder’s estate, and it contributes to pushing the estate’s value above the threshold for inheritance tax. This could potentially reduce the amount received by beneficiaries.

Beneficiaries of the deceased generally do not pay tax on inheritances, because the tax is taken from the estate before anything is passed on to the beneficiaries. However, they may have other related taxes to consider. It’s worth noting that individuals who receive large monetary gifts before the pass away may be subject to inheritance tax. This can affect families who have received over £325,000 and the donor passes away within seven years. If the representative handling the estate was unable to pay the due inheritance tax on the estate, it may then fall to the beneficiaries to do so. Whatever the case, HM Revenue and Customs (HMRC) will get in touch with instructions on what to pay and how to do it.

Certain actions, such as gifting your home to children or grandchildren, can increase your threshold to £500,000. Additionally, if you’re married or in a civil partnership and your estate is worth less than your threshold, any unused threshold can be transferred to your partner upon your death {1}.

The standard Inheritance Tax rate is 40%, applied only to the portion of the estate exceeding the threshold. In certain circumstances, some or all of the estate may be subject to lower rates.

However, there is a way to reduce the likelihood of your beneficiaries losing part of your estate to life policies and inheritance tax.

How to avoid inheritance tax on life insurance

One very effective strategy to protect against life insurance policy inheritance tax is to complete a trust form. Establishing a trust can protect inherited life insurance from being taxable, safeguarding the proceeds for the intended beneficiaries.

By placing the life insurance policy within a trust, the proceeds are separated from the policyholder’s estate, minimising the impact of the 40% inheritance tax. This approach ensures that the intended beneficiaries receive the full benefit of the policy without the burden of taxation. Moreover, putting life insurance in trust allows for greater control over how the funds are distributed.

What is a trust?

A trust manages assets for people, such as money, investments, or property. Following guidance from the GOV.UK website {2}, the role of a trust is outlined below:

Trusts involve:

• The ‘settlor’ puts assets into the trust.
• The ‘trustee’ manages the trust.
• The ‘beneficiary’ benefits from the trust.

What trusts are for:

• Control and protect family assets.
• Manage affairs for minors or incapacitated individuals.
• Facilitate asset transfer during or after one’s lifetime.
• Pass on assets in life or through a will.
• Distribute assets under inheritance rules.

The Role of a settlor:

• Decides how trust assets are used, often detailed in a ‘trust deed’.
• May benefit from the assets, known as a ‘settlor-interested’ trust, with special tax rules.

Trustees:

• Manage assets according to the settlor’s wishes in the trust deed or will.
• Handle day-to-day management and tax obligations.
• Determine asset investment or usage.

Beneficiaries:

• Can be individuals or groups, such as a family.
• May receive income, capital, or both from the trust, depending on its terms.

The Insurance Surgery specialises in addressing your life insurance inquiries related to taxes and trusts. By speaking to one of our protection advisers, you can receive guidance tailored to your circumstances.

Knowing the effects of tax and life insurance payouts and implementing appropriate strategies can help maximise the financial support your loved ones receive. By being proactive and seeking professional advice, you can ensure that your beneficiaries are well taken care of when the time comes.

 To speak with an adviser today, call us on 0800 083 2829 or start a live chat.

 Blog References:

{1} GOV.UK. “How Inheritance Tax works: thresholds, rules and allowances.” Accessed 18^th March 2024. https://www.gov.uk/inheritance-tax

{2} GOV.UK. “Trusts and Taxes.” Accessed 18^th March 2024. https://www.gov.uk/trusts-taxes