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What You Need To Know About Taxable Life Insurance

Two things are certain in life, death and taxes. Life insurance payouts cover both subjects, leaving the ultimate question of whether beneficiaries will have to pay tax on the funds received after they pass away.

Taxes regarding life insurance payouts can get relatively complex, which is why we’ve compiled this guide to understanding how the money gets taxed.

Will My Beneficiary Get Taxed on Life Insurance Payouts?

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Should you die within the agreed terms of your life insurance policy, your beneficiary will claim to receive the stated sum of funds. However, the person in question will probably wonder if the amount they receive is subject to taxation.

The short answer is that no, life insurance payouts do not get taxed, but it isn’t as straightforward as we’d like. No income or capital gains tax applies to the funds. However, there are other instances where the beneficiary may have to pay tax on the amount received.

Let’s look at how taxes apply to life insurance payouts and the circumstances beneficiaries need to note.

How Does Tax Work in Life Insurance?

We’ve mentioned that income and capital gains tax do not apply to life insurance payouts. However, the most significant factor one should be aware of in the policy is inheritance tax (IHT), which can complicate whether you get taxed.

We’ve mentioned that income and capital gains tax do not apply to life insurance payouts.

The principles involved are that taxes do not apply to the life insurance payout. However, inheritance tax may apply if the funds make up part of your estate. Should the value of your combined assets be more than a certain threshold after you pass away, you’ll have to pay IHT.

Again, IHT is not straightforward as there are varying circumstances and scenarios with different tax thresholds. We’ll help give a more concise idea about inheritance tax and how it applies to life insurance payouts below.

What is Inheritance Tax?

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Inheritance Tax (IHT) is the tax that applies to the combined value of assets of a deceased person when transferring them to a beneficiary. The estate usually includes property, cash, investments, and valuable items like jewellery and cars.

If the deceased had any debts, the estate’s total value will minus any outstanding amount, meaning the taxable amount is the value of assets minus the debts. So, where do life insurance payouts fit into the estate?

We’ve already mentioned that life insurance payouts are tax-free and that IHT can apply to the funds you receive. It’s understandable if this may confuse whether you’ll pay tax or not on the funds.

Does IHT Apply to Life Insurance Payouts?

IHT will apply to life insurance payouts if the funds make up part of the deceased’s estate. Suppose the beneficiaries get classified as an ‘estate’, or the money makes up part of your combined assets. In that case, the tax will apply should it exceed a certain threshold.

So what’s this threshold, and what tax rates will apply to the life insurance payout?

How Much Tax Will Apply to the Payout?

Matters can get slightly more complicated when understanding how much IHT you’ll have to pay, as there are varying applications and exceptions. However, the general rule is that 40% of the estate gets taxed when the value exceeds £325,000.

That means anything below that threshold is essentially tax-free. You’ll get an allowance of that amount no matter the estate’s value, but the deal above that threshold will be subject to IHT.

The rules on IHT in the UK tend to change quite swiftly, making matters confusing. But we can outline a few things that prospective life insurance policyholders should make themselves aware of when it comes to IHT and payouts.

  • If you leave property to your children or grandchildren, the IHT tax-free threshold rises to £500,000 (the extra £175,000 is called the ‘residence nil rate band (RNRB’).
  • No IHT applies if your estate goes to your married or civil partner.
  • If your estate is worth more than £2,000,000, the RNRB gets reduced by £1 for every £2.
  • Should a spouse receives the assets tax-free, and the surviving partner passes, the beneficiary gets a combined estate where the IHT threshold is £625,000.

Expert brokers are available if you have any questions about what circumstances could apply to you. Otherwise, we can outline a scenario that will give a general idea of how much tax you will have to pay.

If a life insurance policyholder passes away within their agreed terms:

The payout will form part of the deceased’s estate, with other assets to the beneficiary. The combined value includes a £400,000 property, £50,000 in savings, and a £125,000 life insurance payout – a total estate value of £575,000.

The first £325,000 is tax-free, meaning the 40% IHT will apply to the remaining £250,000 on the estate. The beneficiary will have to pay £100,000 in tax.

Naturally, policyholders and beneficiaries would want to find ways that tax could get minimised, considering the bill can get hefty after exceeding the threshold. Are there any ways to lower or avoid paying tax on life insurance payouts?

Is There Any Way to Avoid Paying Tax on Life Insurance Payouts?

There are ways to minimise and circumvent taxes on life insurance by legal means. We’ll go through a few standard methods to ensure most or the total amount of funds goes to your beneficiary.

Let’s start with querying about payments themselves and if they are tax-deductible.

Is Life Insurance Tax Deductible?

Whether life insurance premiums are tax-deductible is a common question amongst those considering a policy. However, as they get classified as a personal expense, they cannot receive consideration as a business cost.

Subsequently, life insurance premiums are not tax-deductible.

Pass Your Estate to a Spouse or Civil Partner

If you leave your estate to your surviving partner, it is not subject to taxation. However, the beneficiary of the combined estate will have to pay tax when the remaining spouse or civil partner passes, though the IHT threshold rises to £650,000.

Dedicate Funds Towards Paying the IHT

One option you have is that if you know that the value of your estate will likely be when you pass, you can dedicate a portion of the funds to paying the IHT. Executors of your estate can usually help understand how much you’ll need to cordon off, helping your beneficiary understand how much they’ll precisely receive.

Putting Your Life Insurance Payout in Trust

Putting your life insurance payout into a trust is one of the most common ways to avoid tax applying to the funds. The amount gets considered separate from your estate and, therefore, not subject to IHT.

However, suppose you consider putting the life insurance payout in trust. In that case, it might be worth having the policy written into a trust agreement.

How Do I Write My Life Insurance Policy in Trust?

Most insurers will offer the option to write your life insurance policy in trust free of charge. But what does that entail?

What is a Life Insurance Policy in Trust?

Many insurers will offer the option to write your life insurance policy in trust. That means you’ll sign over the plan to a trustee (individual, usually an executor) to manage any funds associated with the asset on your behalf.

As the asset is now under the control of another individual, it does not form part of your estate. It is therefore omitted from IHT after the policyholder passes. The trustee will be responsible for dispersing the funds paid into the trust after death.

You can put your life insurance policy into trust whenever you wish. The recommendation is that the policyholder does this when they take out the plan rather than later down the line.

So why should you write your life insurance policy in trust? Let’s take a look at the benefits.

What are the Benefits of Writing a Life Insurance Policy in Trust?

Advantages to writing your life insurance policy in trust include:

  • Make decisions about who receives the payout – Putting your life insurance policy in trust means it’s more straightforward to disperse funds to selected beneficiaries. The payout forms part of a trust, not your legal estate, so your chosen family members or others can receive the funds directly.
  • Beneficiaries receive funds faster – If your policy is in trust, it won’t be subject to the common obstacles that hinder the process of paying beneficiaries. There are many scenarios where payouts get caught in probate (the process of proving the deceased’s last will), which can take an excessively long time to resolve.
  • Restrict access to money – Should you have young children, you may not want them to have such a significant amount of cash. Putting the policy in trust means you can restrict access to the funds until they reach a responsible age.
  • Only pay IHT on the remaining assets in your estate. Life insurance policies in a trust do not form part of your estate, meaning beneficiaries only have to pay the tax applicable to other assets.

Should you find interest in writing your policy in trust, seek more information from expert brokers to see if it’s right for you.

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