Is Life Insurance Taxable?

Life insurance is designed to provide financial support for your loved ones after you die, but many people are unsure whether the payout from a life insurance policy is taxable in the UK. While the money itself is not considered income and isn’t subject to income tax, it can be caught by Inheritance Tax (IHT), depending on the value of your estate and how the policy is arranged.

This guide explains when life insurance is taxable, how IHT applies, and how you can reduce or avoid tax by placing your policy in trust.

Are Life Insurance Payouts Taxable?

Life insurance payouts are not subject to income tax or capital gains tax. That means if a beneficiary receives a lump sum from your life insurance policy, they don’t need to declare it as income or pay tax on it directly.

However, the payout may form part of your estate, and if your estate exceeds the Inheritance Tax threshold, the proceeds could be taxed at 40 percent.

Who Benefits from a Life Insurance Policy in the UK?

The person or people named as beneficiaries in your policy will receive the payout. If the policy is not written in trust, the money goes into your estate first and is then passed on through your will or intestacy rules.

If the total value of your estate – including property, savings, investments and your life insurance payout – is above the current IHT threshold, tax may be due before your beneficiaries receive anything.

Do I Have to Pay Taxes on Money Received from a Life Insurance Policy?

You won’t pay income tax or capital gains tax on a life insurance payout. But Inheritance Tax may be deducted if the payout increases the value of the estate above the IHT threshold.

As of the 2024-2025 tax year, the Inheritance Tax nil-rate band is £325,000. If your estate is worth more than this and you haven’t taken any steps to reduce the value of your estate, anything above the threshold may be taxed at 40 percent.

If you leave your home to a direct descendant, you may also qualify for the residence nil-rate band, which can increase your tax-free threshold to £500,000.

Life Insurance and Inheritance Tax Example

Let’s say your total estate is worth £600,000, including a £200,000 life insurance payout. If your IHT threshold is £325,000 and you don’t qualify for the residence nil-rate band, your estate could be liable for Inheritance Tax on £275,000 (£600,000 minus £325,000). At 40 percent, that would result in an IHT bill of £110,000 – potentially reducing the amount your beneficiaries receive.

How Do I Get Tax-Free Life Insurance?

To keep your life insurance payout outside of your estate for tax purposes, the most common and effective method is to place your policy in a trust. This means the money is paid directly to your named beneficiaries, bypassing your estate, so it doesn’t count towards the IHT calculation.

You can usually do this for free when you first take out the policy. Most insurers offer a standard trust form which you can complete at the time of application.

Putting Life Insurance Money in a Trust

A trust is a legal arrangement where you give control of your life insurance policy to trustees (often family members or professionals) who manage it for the benefit of your named beneficiaries.

Putting your policy in trust can help:

• Avoid Inheritance Tax on the payout

• Ensure the money goes directly to your chosen beneficiaries

• Speed up the payment process, as probate is not required

Once a policy is placed in trust, you usually can’t change the beneficiaries or access the policy without agreement from all trustees, so it’s important to understand the implications before proceeding.

Are Life Insurance Premiums Tax Deductible?

For most individuals in the UK, life insurance premiums are not tax deductible. This means you pay for the policy with post-tax income.

The exception is for business owners or employers who take out life insurance for employees as part of a group life scheme. In that context, premiums can often be deducted as a business expense.

What Is Inheritance Tax?

Inheritance Tax is a tax on the estate (the property, money and possessions) of someone who has died. The current IHT rate is 40 percent on the portion of the estate above the nil-rate band.

Planning ahead with tools like trusts, gifts and proper estate structuring can help reduce or eliminate the amount of IHT due.

IHT Threshold and Rates 2024-2025

• Nil-rate band: £325,000

• Residence nil-rate band (if passing your home to a direct descendant): £175,000

• IHT rate on amount above threshold: 40 percent

• If 10 percent or more of your estate is left to charity, IHT may be reduced to 36 percent

These thresholds have been frozen until at least 2028.

Can I Give Money Away to Avoid Inheritance Tax?

You can give away money during your lifetime to reduce the value of your estate. Gifts are exempt from IHT if:

• They are less than £3,000 per tax year

• They are small gifts under £250 per person

• They are made more than seven years before death (subject to taper relief)

Using gifts and trusts alongside a life insurance policy can be a powerful way to protect your estate and support your loved ones.

Will I Pay Tax on a Critical Illness Cover Payout?

No. Critical Illness Cover pays out a lump sum if you’re diagnosed with a serious condition during the term of your policy. This money is not taxed, as it’s not treated as income or part of your estate.

It is designed to help with costs like medical treatment, adapting your home, or taking time off work, and is yours to use as needed, tax-free.

Final Thoughts

Life insurance payouts are not taxed as income, but they can become part of your estate and therefore may be subject to Inheritance Tax. If you want your loved ones to receive the full value of your policy, placing it in trust is the most effective way to avoid tax on the payout.

When planning your estate, it’s worth reviewing your cover regularly, especially as tax thresholds, property values and personal circumstances change. If you’re unsure, professional financial advice can help you set things up in the most tax-efficient way possible.