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Life insurance tax

Ellie Austin-Williams
Written by Ellie Austin-Williams

A life insurance policy can be a great way to protect your family from financial difficulties in the event that you pass away. However, it is key to take into account the potential tax implications of life insurance. Without careful planning, your family might find themselves with a large tax bill. This can mean that the financial security you intended to leave behind may disappear. This guide looks at life insurance tax in the UK and how you can best plan for any tax charges.

Is life insurance taxable?

The starting point with life insurance is that usually there is no income or capital gains tax payable on the lump sum policy payout. In certain situations, however, life insurance will be taxable. Typically, life insurance will be taxable if the total value of your estate is more than £325,000, which will trigger an inheritance tax charge. Your estate includes all of your possessions, including property, cars, and cash in the bank, as well as any lump sum from a life insurance policy. 

The rate of inheritance tax is 40%, which can substantially decrease the amount of money that your family receives. This means that whatever the value of your estate over £325,000, your family will receive an inheritance tax bill of 40% of that amount. For example, if you have assets worth £300,000 and a life insurance policy worth £100,000, the 40% tax applies on the £75,000 above the threshold. 

Although in some areas of the UK the threshold for inheritance tax might seem high, in other areas such as London, the average house price is far higher than the £325,000 threshold.  This means that some families can quickly hit the upper tax-free limit. For this reason, it’s worthwhile spending some time to ensure that your life insurance policy payout will be tax-free.

How to avoid a life insurance inheritance tax bill

A key factor which determines whether your policy will attract an inheritance tax liability is whether it is a ‘qualifying’ or ‘non-qualifying’ policy. ‘Non-qualifying’ policies are usually liable for income tax. 

There are complex requirements for each type of policy. If you are unsure about which type of policy you have. Ask your insurance provider for guidance or speak to an insurance specialist.

There are also some legal ways that you can organise your life insurance policy to avoid inheritance tax charges in the event of your death. 

Put your life insurance policy in trust

Rather than your life insurance payout forming part of your estate when you pass away, you can set up a legal structure known as a trust. A trust separates your life insurance policy from your estate and enables the trustees to look after the policy. 

The trustees become the legal owners of the insurance policy. They oversee the policy, making sure that the money from the life insurance goes to the specified beneficiaries. You can choose whether a family member or your solicitor becomes the trustee and handles the payout on your behalf.

When you take out a life insurance policy, your insurance provider will usually offer you the option of setting up a trust for free. This allows you to put the policy in trust from day one. Setting up a trust is a simple process and this way, you won’t have to worry about any tax implications later on.

How does a trust work?

Putting your life insurance policy in trust can be beneficial for a number of reasons. A trust structure avoids an inheritance tax charge, because it is separate from your estate. It is your estate that is liable for inheritance tax when you pass away. 

When you put a life insurance policy in trust, you maintain full control over the beneficiaries. When you take out the policy, you specify who you wish to benefit from the policy. You can change the beneficiaries through the policy term if you later decide to do so.

Using a trust structure can often help speed up the process of receiving the lump sum following a death. The life insurance policy will fall outside of the estate and will not be held up in the administrative process that follows a death. This is particularly helpful if you have planned for your funeral costs to be paid for out of the life insurance payout.

Leave your assets to a partner

If you pass away and leave your assets to a spouse or civil partner, your assets and tax-free allowance transfer to your surviving partner. Under the inheritance tax law in the UK, everything left to your spouse or civil partner will be tax-free. If you haven’t used your full allowance at the time of your death, your spouse or partner can benefit from any remaining allowance. This will increase their overall tax-free allowance. 

What are the different types of life insurance?

There is a range of options available when it comes to life insurance. Taking out a life insurance policy can be one way to provide financial security for your family, as well as peace of mind for you. A life insurance policy can ensure that if you pass away during the term of your life insurance, your family will not struggle financially.

You can use a life insurance policy to pay for all types of financial commitment, such as a mortgage, funeral costs or school fees. You may simply use a life insurance policy to help your family maintain their lifestyle if you pass away. There are various forms of life insurance, however, the most common policies are level term insurance and decreasing term insurance.

Level term life insurance

When you take out a level term insurance policy, you specify a fixed lump sum. Your family will receive the lump sum amount in the event of your death during the policy term. The policy term is a fixed period which you determine when you take out the insurance, and the lump sum amount remains the same through the entire term. This means that you know exactly how much your family would receive as a lump sum. Note that level term insurance doesn’t account for inflation.

Decreasing term life insurance

Designed to cover a debt which reduces over time - such as a repayment mortgage - this type of life insurance is also known as mortgage protection insurance. The term of a decreasing life insurance policy is often the same length as the debt repayment plan. With this policy, the value of the insurance lump sum decreases over time in line with the amount of outstanding debt. This means that premiums are usually lower on decreasing term policies than level term insurance. 

Increasing term life insurance

Level term policies guarantee a lump sum payment if you die during the term of the policy. However, level term policies don’t factor in inflation and the payout sum stays the same. The result is that a £100,000 payout will have a lower real value at the end of the term after 15 years, for example, than when you take out the policy in year one. 

Increasing term life insurance combats this discrepancy and ensures that the value of a lump sum remains the same. With an increasing term policy, the lump sum will either rise in line with inflation each year, or it will increase by a fixed amount that is higher than the inflation rate.

Speak to an expert

If you aren’t sure whether your life insurance is taxable or you want to better understand the tax implications of a life insurance policy, it is advisable to speak to an expert. This will ensure you get the best advice for you and your circumstances.

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27th August 2020