Do you pay tax on a life insurance payout?
The main purpose of life insurance is to protect your family and your home if you die during the term of the policy. When you pass away, your family will receive a lump sum that will be paid to them, but the question is, do you pay tax on a life insurance payout?
How is life insurance taxed?
As a rule, life insurance premiums and payouts are not taxed in the UK, however, there may be tax elements that apply in certain circumstances. The main type of tax that you’ll need to consider is Inheritance Tax (IHT) which can be payable over a certain threshold.
Most life insurance policies will therefore be exempt from paying inheritance tax bills and there are ways to even avoid paying IHT on life insurance payouts. For more information you can read this article or you can speak to a life insurance advisor.
Inheritance tax rates for life insurance
You may have heard of inheritance tax before, but if not, then this is a tax that is payable on money that forms part of your inheritance, over a certain threshold. Inheritance tax or IHT, as it is also known, is most commonly charged at a rate of 40% for the net amount of any funds within your inheritance over the IHT threshold.
IHT thresholds are set within the annual budget and will usually remain the same for two years following any announcement. The other thing to consider is that IHT threshold can also be combined to create a joint if it is not used by your spouse or civil partner.
Can I reduce the tax liability for life insurance payouts?
There are some options available to you that can help to reduce or even remove any potential tax liability. This is called a ‘Trust Deed’ which is a legal arrangement that assigns a beneficiary or beneficiaries and Trustees to your life insurance policy.
What is a life insurance trust?
A trust is a legal document that will circumnavigate the process of probate and therefore avoids any payout forming part of your estate. If you put your life insurance policy in a trust then your payout will not form part of your inheritance from a legal perspective.
The trust document has a trustee who is responsible for the distribution of any funds to be paid out, a settlor who is usually the person covered by the policy, and a beneficiary or beneficiaries.
There are several different types of trust documents and you can choose which type of trust is best for you. Setting up a trust can seem complicated so if you are unsure of how to do this, you should speak to a financial advisor for more advice.
You can also find out more about trusts in our guide to life insurance trusts.