Life insurance tax: Are your payouts taxable and how does a trust help?

Is a life insurance payout taxable in the UK?

In most cases, life insurance payouts in the UK are:

• Free from income tax
• Free from capital gains tax

But, there’s one important exception: if the payout forms part of your legal estate when you die, it could become liable for Inheritance Tax (IHT).

What is inheritance tax?

IHT is a tax charged on estates above certain thresholds.

Currently in the UK:

• The standard nil-rate band is £325,000 – in other words, no IHT is payable on an estate below the £325,000 threshold
• Inheritance tax is usually charged at 40% on the amount above this threshold

There are further allowances, particularly if you’re passing on a home.

You can leave your primary property (the home in which you live) to your husband, wife or civil partner with no tax implications. This means the IHT amount only covers assets other than your main home. This can potentially increase the tax-free threshold significantly for married couples or civil partners.

Note that this does not apply to cohabiting partners.

If you pass on your home to a direct descendant, the tax-free threshold rises to £500,000. This is the standard nil-rate band of £325,000 plus the residence nil-rate band (RNRB), which is £175,000 per person.

This applies if:

• You leave your home to your children (including adopted, foster or stepchildren) or grandchildren
• Your estate is worth less than £2 million

You can read more on the official HMRC inheritance tax guidance.

How can I make my life insurance payout tax-free?

One of the most common ways to reduce the risk of inheritance tax on life insurance is by writing the policy in trust.

What is a trust?

A trust is a legal arrangement where ownership of an asset is transferred to trustees. The asset can be things like money, property, land or investments. In this case, the asset is the life insurance policy.

The trustees manage the payout on behalf of your chosen beneficiaries.

Putting a life insurance policy into trust usually means the payout:

• Doesn’t form part of your estate
• Can bypass inheritance tax
• May be paid out more quickly because probate is avoided, which is the granting of rights to the deceased’s estate

Who are the trustees?

Trustees are the people responsible for managing the payout according to your wishes. People tend to choose someone they trust (hence the name), like:

• A partner
• Family members
• Close friends
• Professional advisers

To help guide them, you can provide a letter of wishes along with the trust. This is a document explaining how you’d like the trustees to distribute the money. While it isn’t legally binding, it helps trustees when making decisions.

How do I put a policy in trust?

Most insurers provide trust forms free of charge. You’ll usually need to:

1. Contact your life insurance provider
2. Complete trust paperwork
3. Choose trustees and beneficiaries

Many policies can be written in trust when you apply, although some insurers allow this later too. You can learn more about trusts on GOV.UK’s trust guidance.

How is inheritance tax calculated on an estate?

Your estate includes the total value of your:

• Property
• Savings and investments
• Possessions
• Cash assets
• Life insurance payouts not written in trust

Under current inheritance tax rules, the nil-rate band (NRB) is £325,000 per person. In other words, this is the tax-free threshold.

For married couples and civil partners, unused allowance can often be transferred, potentially creating a combined threshold of £650,000.

As mentioned, an additional allowance may apply if you leave your main home to direct descendants. As it stands, the residence nil-rate band (RNRB) is up to £175,000 per person.

Combined with transferable allowances, some couples may be able to pass on up to £1 million before Inheritance Tax applies.

Example of a taxable life insurance payout

Let’s say:

• Your estate is worth £500,000
• Your life insurance payout of £200,000 is not written in trust

In this instance, the total estate value could become £700,000 for inheritance tax purposes.

This means that – depending on available allowances – part of the payout could potentially become taxable.

So, if you weren’t passing on your home to your partner or direct descendants, the total estate value exceeds the threshold by £50,000 – which is the amount that would be subject to IHT. At 40%, that’s £20,000 that goes to HMRC.

What is a ‘gift’ in inheritance tax?

A gift is money, property or possessions given away during your lifetime.

Some gifts may still count towards inheritance tax if you die within seven years of making them – often referred to as the ‘seven-year rule’.

Why it’s important to act early

Writing a policy into trust is generally most effective when done well before any serious health concerns arise. For example, if you were diagnosed with terminal cancer and then tried to set up a trust to avoid tax, this could cause serious issues.

If changes are made shortly before death with the intention of avoiding tax, HMRC may investigate the arrangement more closely. Because trusts can be difficult to reverse, it might be worth seeking professional financial or legal advice before making any changes.