Do You Pay Inheritance Tax on Life Insurance?

Life insurance is a vital safety net for families across the UK. With a generous life insurance payout, your loved ones can access the financial support they need after your death, helping them cover funeral expenses, mortgage repayments, bills and utilities, education costs and other general living expenses.

However, many people worry about the taxman taking a huge chunk of their life savings, which can mean that their families don’t receive as much as anticipated. In this article, you’ll learn about paying tax on your life insurance, inheritance tax rules and regulations, and how to legally pay less tax on your estate after your death.

In This Guide:

Is Life Insurance Taxable?

A life insurance policy pays your beneficiaries a lump sum of money after your death. Luckily, you won’t have to pay income tax or capital gains tax on this life insurance payout. This means that the payout itself is tax-free.

However, unless you write your life insurance policy in trust (more on this later), your life insurance proceeds will form part of your estate upon your death rather than going straight to your named beneficiaries. Therefore, if your estate is subject to inheritance tax, this means that the money from your life insurance could be taxed too.

What Is Inheritance Tax?

Inheritance tax is levied on the value of your estate after you die. Currently, this is a 40% tax above the threshold of £325,000, which is called the nil rate band.

Your estate includes anything you own at the time of your death, such as your home, car, possessions, money, life insurance payouts and other assets. Therefore, if you had an estate worth £600,000, your heirs would have to pay £110,000 in inheritance tax from your estate. If they don’t pay this within six months, they’ll have to pay interest on what they owe.

If you’re married or in a civil partnership, you can transfer all of your estate and any unused nil rate band allowance to your partner upon your death. This allows you to combine your £325,000 thresholds to double your nil rate band, meaning that your inheritance tax threshold will now be £650,000.

Residence Nil Rate Band

Another way to increase your inheritance tax threshold is to leave your home to a direct descendant, such as your child, step-child or grandchild. By doing this, you can add an extra £175,000 to your tax threshold. This is called the residence nil rate band.

If you transfer your unused tax-free allowance to your spouse and you both decide to leave your home to your children, you could potentially increase your inheritance tax threshold up to £1 million.

However, you should be aware that the total residence nil rate band only applies to estates worth less than £2 million. If your estate is worth more than this, the band will decrease by £1 for every £2 over £2 million that your estate is worth.

Calculating the Value of Your Estate

As demonstrated above, being aware of the value of your estate and the current inheritance tax thresholds prior to your death can help you manage your affairs so that your heirs can legally pay less tax.

To work out the value of your estate, you should add up the value of all your assets and cash. This includes things like properties, cars, land, possessions, shares and insurance policy payouts. Then, you need to subtract the value of outstanding debts such as mortgages and loans, including credit card loans. This final total is the value of your estate.

If this total is over the £325,000 threshold (or £650,000 if you transfer your tax-free allowance to your surviving spouse), then your heirs will have to pay inheritance tax on any money above the threshold, including proceeds from your insurance policies. Unfortunately, due to rising house prices, more families than ever will now be faced with an inheritance tax bill following the death of a loved one.

It’s a good idea to keep a record of these calculations. This will help speed up the process of paying inheritance tax and passing on the estate after your death.

Inheritance Tax: Life Insurance Paying Your Tax Bill

Can you use your life insurance policy to pay your inheritance tax?

Although life insurance policies are often used to cover mortgage repayments and general living expenses, you could absolutely take out a life insurance policy specifically to cover an inheritance tax bill if you know your estate will be over the threshold.

If you work out the value of your estate and discover what the inheritance tax bill will be, you can take out a life insurance policy to cover this amount. This will take away one more source of stress for your grieving family at a difficult time.

Once you have an amount in mind, you’ll need to find an appropriate policy. Whole-of-life insurance policies can typically offer a large lump sum of cash and the security of a guaranteed payout, but the life insurance premiums will be more expensive. On the other hand, over 50s policies are great for older people who want manageable monthly premiums and no medical questions, but the payout may not be enough to cover your inheritance tax bill, especially if you have a large estate.

However, you’ll still have to consider that your life insurance payout may be reduced considerably if it’s subject to inheritance tax. The only way to get around this is to write your life insurance policy in trust, as this can help your beneficiaries receive the full amount and use it to cover other bills and expenses.

Writing Your Life Insurance Policy in Trust

Writing your life insurance in trust means that the payout will go directly to your beneficiaries upon your death instead of being part of your estate. As your life insurance proceeds won’t be counted as part of the value of your estate, this money won’t be subject to inheritance tax.

A trust is a legal arrangement that appoints a trustee or trustees to hold assets on behalf of a beneficiary or beneficiaries. When you write your life insurance policy in trust, you appoint a trustee (such as a friend or solicitor) to look after the policy for you and pass the money on to your beneficiaries when you die.

You can put your policy in trust when you first take it out (at no extra cost) or you can decide to do this at any time. However, make sure that you fully think through this decision beforehand, as it may not be possible to reverse it later.

Here are the main benefits of putting your life insurance in trust:

  • You technically don’t own your policy as part of your estate, which means your heirs won’t need to pay inheritance tax on this money, even if the total value of your estate is over the nil rate band.
  • Your beneficiaries will receive the life insurance money more quickly because writing the policy in trust means that it bypasses probate, which is the legal process of sorting out a deceased person’s estate. Receiving the money promptly can help your beneficiaries sort out mortgage repayments, taxes, bills and other expenses as soon as possible.
  • You can control exactly who the money goes to by naming your beneficiaries and appointing trustees to manage the funds. This is particularly important if you want to leave money to your partner but you aren’t married, as long-term partners aren’t entitled to any of your assets if you die without a will.

Most life insurance policies can be written in trust, but please bear in mind that there are some non-qualifying policies too. Make sure you do your research beforehand and speak to an independent financial adviser if necessary for further guidance.

Cash Gifts

Writing your life insurance in trust isn’t the only way to legally avoid inheritance tax. Giving cash gifts to your loved ones before your death will reduce the overall value of your legal estate, thus reducing your inheritance tax liability.

You can give up to £3,000 each tax year to your loved ones without incurring inheritance tax. No tax has to be paid on gifts between spouses or civil partners, and there are additional types of cash gifts you can give tax-free depending on your relationship with the beneficiary. For example, a parent can give £5,000 to their child as a wedding gift without incurring inheritance tax, and a grandparent could give up to £2,500 to their grandchild for this purpose.

However, larger cash gifts could be liable for inheritance tax if they’re given in the seven years before someone’s death. The amount of tax owed will vary depending on the value and when the gift was given (cash gifts given three to seven years before someone’s death will be taxed on a sliding scale from 40% to 0%).


Finally, another option is to make a charitable donation in your will. Again, this will reduce the overall value of your estate and therefore reduce the amount of inheritance tax you have to pay. 

Additionally, donating to charity can actually reduce your inheritance tax rate. By donating at least 10% of your estate to a legitimate charity, your inheritance tax rate can go down from 40% to 36%, which can make a significant difference to the amount you leave behind for your family members.

Tax and Life Insurance

So, do you pay tax on life insurance payouts in the UK?

Although the payout itself is tax-free, your family may end up paying inheritance tax on this money at a rate of 40% if your estate is valued at over £325,000 after your death. You can increase this threshold to potentially £1 million by transferring your nil rate band allowance to your spouse or civil partner and leaving your home to your children, but the fact remains that inheritance tax could end up taking a bite out of your life insurance proceeds.

To combat this, you need a life insurance policy that can offer you enough coverage to offset this potential loss. Here at Money Expert, we can help you compare quotes and policies to find the right life insurance provider for you. So, whether you want a whole-of-life policy, term life insurance or an over 50s plan, you can get the life cover you need and provide financial security for your family.