Is life insurance subject to inheritance tax?

It's always reassuring to know that your family/loved ones will be taken care of financially when you're gone. Policies like life insurance could provide them with a cash lump sum if anything happens to you, but will any of this money be taxed, especially inheritance tax?

In this article, we'll look at how inheritance tax could affect your life insurance policy and what you can do to protect your policy from being taxed.

Is life insurance taxed in the UK?

There is no specific tax on life insurance, and most policies are excluded from UK income tax. However, the proceeds from the policy may be subject to inheritance tax (IHT) if it is part of the policyholder's estate.

For more information, please read: Can life insurance form part of an estate?

What is inheritance tax?

Inheritance tax is a levy used by the UK government, applied to the value of a person's estate when they pass away. The total estate can include any assets owned, such as property, savings, possessions such as jewellery, and even life insurance.

As of the 2024-2025 tax year, estates valued over £325,000 may be liable for inheritance tax at a rate of 40% on the amount above this threshold. IHT will apply once any debts owed or funeral expenses have been deducted from the estate.

There are some instances where the threshold can be increased:

• Your estate includes a residence that is passed on to your children or grandchildren, which can raise the threshold to £500,000 (if your home is worth less than £2 million).
   

• Anything you leave to your spouse or civil partner won't be subject to IHT, even if the total amount is above the threshold. This is known as the 'nil-rate band'.

The tax rate of IHT can be reduced to 36% on some assets if you leave 10% or more of the net value (the estate’s total value minus any debts) to charity in your will.

As of now, the inheritance tax allowance is frozen at £325,000 until April 2028.

Do life insurance payouts fall under inheritance tax?

To the government, life insurance is deemed an asset, therefore the cover amount of a life insurance policy can be included in an estate's total value.

If the value of your policy plus the value of your other assets exceeds the inheritance tax threshold, then the proceeds from that policy will be subject to inheritance tax when you pass away.

However, if the total value of the estate is below the threshold, no tax will apply, and your beneficiaries will receive the full amount owed from the policy. In this case, it will still need to be reported to HMRC.

In certain situations, tax could be payable on the policy if:

• Interest has been earned on the policy in the period between your death and the payout to your beneficiaries, which would be subject to income tax.
   

• The policy included an investment element, which may also generate gains that could be subject to capital gains tax.

How to calculate the value of your estate

It can be hard to determine the exact value of your estate, especially when considering various assets and liabilities. Here are some steps to help you calculate it:

1. List your assets

Begin by listing all the assets you own, including but not limited to:

• Property (homes, land)
   

• Cash savings and investments (stocks)
   

• Personal possessions (jewellery, art, cars)

3. Calculate the total of your assets

Add up the cost of all your assets to get your total estate value.

4. List your outgoings

Make a list of any payments you owe, which could be repaid through your estate. This can include:

• Mortgages
   

• Loans
   

• Credit card debt
   

• Funeral expenses

5. Calculate the net value of your estate

By subtracting the deductions from the total assets, you will have the net value of your estate. If this is under the IHT threshold, your estate will likely avoid inheritance tax when you die. 

However, your circumstances could change between now and your death. Make sure to account for any significant financial changes or purchases to your estates value.

How can I prevent my policy from being taxed?

One of the best ways to protect your life insurance policy from a potential inheritance tax is to write it in trust. By doing so, the proceeds of your policy can be paid directly to your beneficiaries upon your death, bypassing your estate entirely.

This means that the value of the policy will not be included when calculating the total value of your estate for IHT purposes.

If the value of your estate is likely to exceed the IHT threshold, writing your policy in trust could be a good way to ensure that your family and/or loved ones receive the full amount without having to pay any tax.

Learn more about writing your policy in trust