Life insurance is largely meant to fund the financial difficulties and gaps left behind after someone dies, but is the cash that is paid out subject to any tax that will potentially diminish its value?
In this article, we explain how life insurance payouts are potentially subject to tax and the best way to avoid this tax. You can also speak to an expert life insurance adviser to arrange your life insurance in ways that will prevent any tax issues and you will get up to £100 cashback* if you buy your life insurance this way.
Are life insurance payouts taxed?
Life insurance is not taxed when it pays out in the UK, but there are instances where it may become liable for Inheritance Tax (IHT) so it is important to arrange your life insurance policy in a way that avoids any potential tax implications when you die.
Life insurance is usually only taxed if it forms part of the deceased person's estate and the value of the estate, including the life insurance payout, exceeds the allowable inheritance tax thresholds. There is no inheritance tax payable when assets are passed between spouses.
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How is inheritance tax calculated for life insurance?
Inheritance tax is usually charged at up to 40% of the net value of your estate that exceeds the allowable threshold and can include gifts made during your life. For the year 2024/25 the inheritance tax threshold is £325,000 per person. You can pass any unused allowance to your spouse when you die so the personal inheritance tax allowance can be as much as £650,000 if your spouse doesn't use their allowance and instead passes this onto you.
You can find detailed information about this calculation in our article, "How to calculate inheritance tax and our free IHT calculator".
How to use a Trust to avoid tax on life insurance
Trusts can allow you to give assets to your beneficiaries before you die so that the assets don't form part of your estate upon death. A Trust is a legal document that assigns trustees responsible for distributing the money paid into the trust according to how the settlor (usually the person who is insured) sets out. The settlor will usually nominate beneficiaries as well as how the money should be split.
Ultimately, when your life insurance payout is paid into a Trust, the money bypasses your estate and therefore it does not go through the probate process. This means that it is paid in full without a tax charge. The process will also avoid the lengthy delays that can be caused by the probate process.
To read more about trusts and how to assign benefits and the guardians for life insurance benefits, read our article, "Writing your life insurance in trust – How it works and why you should consider it".
How tax is applied to single and joint life insurance policies
If an insured person dies, the life insurance pays out into their estate and is combined with their other assets and possessions. All of these assets then go through the probate process and are distributed according to the wishes they set out in a will. If you have not completed a will then your estate is distributed according to the rules of intestacy.
How your life insurance policy is set up is also a determining factor in who will receive the payout from your life insurance. It will be distributed differently depending on whether it is a joint or single life insurance policy and whether you have completed a legal trust document.
Joint life insurance payout - will it be taxed?
A joint life insurance policy that has a trust arranged with it will pay out according to the nominations within the trust. Joint life insurance policies cover two people but even in a situation where both insured people died, there would only be one payout and that payout would be distributed to the beneficiaries nominated within the trust - a process that falls to the trustees to execute.
Without a trust in place, the money paid from a joint life insurance policy, if it isn't paid to a spouse, could still be liable for inheritance tax if, when combined with the value of your entire estate, it exceeds the allowable tax threshold.
Single life insurance payout - will it be taxed?
An individual who is covered by a single life insurance policy and is the policy owner can arrange a trust to assign the payout from the life insurance to their desired beneficiaries, should they die.
If you have not nominated a beneficiary to receive the money that is paid from your individual or single life insurance policy, the money will be passed to your estate. Once the money is paid to the estate then the estate is usually distributed through a process of probate. Again, if the net value of the entire estate exceeds the allowable threshold then your life insurance payout could be subject to inheritance tax.
How is a group life insurance payout taxed?
Group life insurance schemes are usually linked to a master trust which means that the payout money does not form part of the deceased person's estate and thus doesn't become liable for inheritance tax.
If you are a member of a group life insurance scheme, these are usually set up with a master trust that allocates any death benefit according to an instruction of nomination. If you have not completed a nomination form to indicate how you would like your death benefits to be distributed if you die, the death benefit will be distributed according to the rules within the master trust. However, most people will complete a nomination form when they join a group life insurance scheme and any death benefit will be distributed through the trust to the person(s) they indicate as their beneficiary.
You can read more detailed information about group life insurance in our article, "A guide to group life insurance" as there can be tax implications you should consider if you are a higher earner who may breach their lifetime allowance limit.
How to make sure your life insurance payout is not taxed
Trusts are a good vehicle for ensuring that your life insurance payout does not form part of your estate and becomes liable for inheritance tax when you die. They also have the advantage of ensuring that your beneficiaries are named and where necessary, you have stipulated what portion of the payout is to be distributed to each person.
Trustees have the responsibility of allocating the payout from a death claim according to the wishes detailed within the trust and have a legal obligation to ensure that this is done. Where beneficiaries are not of adult age, the trustees can be very useful in managing the monies on their behalf. In cases where the beneficiaries are of adult age, they can usually be nominated as trustees as well.
Without a Trust, most life insurance payouts will end up forming part of the deceased person's estate and should that estate exceed the allowable inheritance tax thresholds, the money will become liable for inheritance tax.
How to arrange a trust to avoid inheritance tax on life insurance proceeds
Putting your life insurance policy in trust is a fairly straightforward exercise. Trusts can be arranged directly through your life insurance provider, a life insurance specialist, or a solicitor. Solicitors will usually charge a fee for this service whereas many life insurance specialists* will support you to arrange a trust without any extra fee.
It is usually best to arrange a trust when you start your life insurance as many life insurance companies provide electronic forms and a slightly more streamlined way of completing a trust when you apply for your life insurance. This process can be a little more cumbersome if you try to arrange the trust after your life insurance policy is up and running.
Further reading
Do you need to worry about inheritance tax?
39 simple ways to pay less tax
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