The Tax Implications of Life Insurance Payouts

A life insurance policy is probably the most important optional insurance you’ll ever take out. There are many forms of insurance that we are obliged to have, for our cars and homes, for example. On the whole, policies like these are for the benefit of others – mortgage lenders and other road users. But the people who will benefit from our life insurance are family.

It is very common for people to take out a life policy to protect their loved ones. Not only does it add to the estate we can pass on, but it can be used to pay off outstanding loans such as mortgages. Instead of leaving a surviving partner or family members with the debt, it can be cleared upon our death.

But the sums involved can be quite large so doesn’t that mean there’s a chance that HMRC will want a share?

The basic position is that there is no income tax or capital gains tax to be paid on a life insurance payout. That’s the good news. The bad news is that there could be inheritance tax to pay, if the proceeds of the insurance claim are counted as part of your estate. Let’s look first at how inheritance tax works.

What is Inheritance Tax (IHT)?

IHT is a tax on everything of value left behind when a person dies, known as their estate. The rate of IHT is a flat 40% which will have to be paid by the heirs of the deceased. However, as is the case with income tax, there is a minimum level or threshold before any tax becomes due. Currently, if the estate is worth a maximum of £325,000 then it falls into the Nil Rate Band and no tax is payable.

On anything above £325,000, 40% tax will be due. For example, if your estate is worth £500,000 then £175,000 is taxable, which means £70,000 must be paid. The exception to this is the situation in which everything above the threshold is left to your spouse or civil partner or to a charity or other organisation that does not have to pay tax.

Is My Life Insurance Part of My Estate?

People take out life insurance for the sake of other people. The only person who cannot benefit is the person insured because the policy only pays out on their death. Unfortunately, Her Majesty’s Revenue and Customs (HMRC) sees it slightly differently. They consider any payout from a life insurance policy to be part of your estate which means if its value takes your estate over the £325,000 threshold there will be tax to pay on it.

Many people take out a life insurance policy in order to relieve their heirs of the tax burden, intending any tax to be paid from the life insurance. We’ll look at this in more detail in a moment. But first, let’s consider whether there is any way to avoid IHT on the payout.

Putting Life Insurance in Trust

This is the simplest option. It works by making a legal arrangement under which trustees are given control of the policy on behalf of its intended beneficiaries. Trustees can be solicitors, family members, friends or practically anyone who is capable of taking on the responsibility. They will then look after the policy during your life until the time comes for the money to be passed on. Because the policy is not under your control but that of the trustees, it is not classed as being part of your estate.

Most life insurance providers will be able to help you do this without any extra charge so you shouldn’t have to worry about expensive solicitors’ fees. All you’ll need to do is decide who your trustees will be and then sign the document your insurers will prepare for you. It makes sense to create the trust at the same as you take out the policy but this isn’t essential – you can place it in trust at any time.

The Advantages of Putting Your Life insurance in Trust

The obvious one is to avoid the risk of losing 40% of the payout in tax but there are other benefits. One is that, although you are technically giving up control of the policy, you have complete freedom to appoint the trustees so you can make sure the people in charge are people you can depend on. It also makes it possible to name the individuals whom you wish to benefit from the policy. Setting up a trust can be particularly useful if you’re not married or in a civil partnership because it eliminates any uncertainty and ensures the money goes to the people you have chosen.

Another big advantage is the speed at which the payout can be passed to your beneficiaries. In many cases, before the executor of a will can start to distribute assets from the estate of the deceased they need what is called a grant of probate. This gives them the legal authority they need to do their job. Probate is usually required if the estate is complex, but if it is fairly small or the assets are jointly owned with a spouse or partner (who will automatically inherit them) then it may not be necessary.

If probate is required the process can take several months. If your life insurance policy has been placed in trust then it is not part of the estate and can be paid over almost immediately.

When Tax Liability Cannot Be Avoided

There are three situations in which life insurance policies – or elements of them cannot be exempted from tax.

In the first hypothetical instance we are talking about income tax rather than IHT. Some policies are classed as non-qualifying, which means they include some kind of investment element. It is not easy to determine what ‘non-qualifying’ means so you should check this with your insurer or an independent advisor if you use one. A qualifying policy is not taxable. However, even a non-qualifying, taxable policy usually allows you to withdraw up to 5% of the investment amount without incurring any immediate tax liability.

In the second situation, if any interest has been earned on the lump sum payout during the time between the death of the insured and the transfer to their beneficiaries, then this could be treated separately from the basic amount and taxed accordingly.

The third possibility is that a beneficiary might be classed as an estate rather than an individual. If this is the case, and the estate of the policyholder exceeds the £325,000 threshold, then it may not be possible to avoid liability for tax.

Using Life Insurance to Pay the Inheritance Tax Bill

The speed of payment we’ve just mentioned is significant in this context, and we’ll come to that in a moment. First, we’ll consider whether and how you can use your policy to remove any tax liability from your heirs.

Inheritance Tax takes priority as is the case with tax in most situations. The law guarantees that HMRC receives the full amount due. For this reason, IHT must be paid before any of the beneficiaries of your will receive anything from your estate. This can obviously create difficulties because they are being asked to pay tax on money they haven’t yet received, so where is that tax supposed to come from?

If you take out a whole-of-life insurance policy, which will remain in force until your death, this can be used to cover any IHT bill, provided you place the policy in trust. Because this allows the payout to be made before the assets in your estate are distributed your beneficiaries will be able to use it to cover the upfront demand for tax payment. Without these, they will have to find thousands if not tens or hundreds of thousands of pounds to pay the bill before they see a penny of the money they are paying the tax on. This could force them to take out substantial loans or remortgage properties, which was never something you envisaged.

The Tax Status of Life Insurance During the Policyholder’s Life

While it is important to put in place the correct arrangements to ensure your policy payout is used as you intended, it is worth considering how the premiums you pay are treated for tax purposes during your life. Most life insurance policies fall outside the scope of the UK income tax regime so although some other insurances may be tax-deductible, in the vast majority of cases, life insurance premiums will not be. The rule is not 100% rigid so you should check with your insurer whether any exceptions apply in your case.

Any life insurance policy is a valuable asset. It is not unusual for policyholders to sell part or all of their life insurance policy to a company in return for a cash payment if they need to release funds urgently. This is perfectly legal but the amount they receive will be counted as a taxable gain and tax must be paid. The tax calculation can be quite complicated so before you attempt to cash in you will need to seek specialist advice to minimise your liability as far as possible.

Some life insurance policies entitle the policyholder to receive dividends which are regular payments from the profits the policy is achieving. This type of policy is known as a ‘participating policy’. The basic position is that you will not have to pay income tax on these dividends but you could be liable if any dividend should exceed the total of your policy premiums.

If your employer provides you with life insurance, you shouldn’t have to pay tax as it is not considered a benefit in kind. In any case, this kind of group life insurance is usually placed in trust so would not form part of your estate.

It is rare but possible for policyholders to surrender their policies in return for a cash lump sum. If their circumstances have changed and they need to get their hands on substantial funds urgently, this is an obvious way to do it. However, HMRC considers this to be income so you will have to pay income tax at your normal rate.

If in Doubt, Ask

As you can see, the tax implications of life insurance payouts and the payment of premiums can be complicated. Nothing in the UK tax system is 100% fixed in stone. There are often exceptions, exemptions, variations and special circumstances but these are not always obvious to the average person. Life insurance policies are a very highly effective way of providing for your loved ones and to shield them from tax and other debts after your death, provided that you get the details right. This guide is intended to make you aware that it is not a straightforward process. Always seek independent professional advice.