Is life insurance taxable? Income tax and inheritance tax on payouts

Usually not, for an ordinary life insurance policy. Payouts aren't taxed as income, but they may be added to the value of your estate and face Inheritance Tax.

Insurers say much the same in their policy documents. The wording varies, and several add that this applies under current tax rules, which may change.

A term life insurance policy's surrender value (the cash you'd get for cashing it in) is usually nil. HMRC's legislation calls a policy with no surrender value, and no way of acquiring one, a 'pure protection' policy. The term also covers policies whose benefits can't exceed the premiums paid, except on death or disability.

HMRC's policy gain rules also leave out policies designed only to pay off a repayment mortgage if an individual borrower dies. These reducing-term policies have no investment element and should build up no surrender value. So they're unlikely to produce a gain anyway.

Some whole of life plans are different. They invest your premiums and build up a cash value. When a policy like that produces a 'chargeable event gain' (a policy gain taxed as income), Income Tax can apply. See taxable gains on a policy for how qualifying and non-qualifying policies differ.

Inheritance Tax can apply when the payout forms part of your estate. It's a tax on the estate (property, money and possessions) of someone who has died. So whether a payout counts depends on where the policy pays out.

When you die, the money goes to whoever owns the policy, or to someone else named in its terms. HMRC's manual says that if the policy is on your own life, the payout forms part of your estate and is taxable on your death.

Payments made on death, such as a life insurance payout or a pension lump-sum death benefit, are among the assets counted when an estate is valued for Inheritance Tax.

Where the money goes depends on how your policy is set up:

• To your estate, if there's no trust or other legal arrangement in place. Guardian, for example, pays the executors or administrators (the people who deal with the estate) after proof of probate, or confirmation in Scotland. At Legal & General, a payout from a policy not written in trust will normally go into the estate.
• To trustees, if the policy is written in trust. MoneyHelper says the policy's value then isn't considered part of your estate and can be paid outside probate and Inheritance Tax.
• To a nominated beneficiary. Some insurers let you name who receives the payout without a trust. Guardian says its Payout Planner pays beneficiaries under contract law, so the payout isn't part of the estate. It says the money then isn't subject to Inheritance Tax and bypasses probate. Royal London says nominating a beneficiary may reduce or avoid Inheritance Tax on a claim.

Being part of the estate doesn't by itself mean tax is due. Inheritance Tax is only charged on the part of an estate above the threshold. There's normally none to pay if everything above it is left to a spouse or civil partner.

There's normally no Inheritance Tax to pay if your estate is worth less than £325,000. Above that, the standard rate is 40%, charged only on the part above the threshold.

There's also normally no Inheritance Tax if you leave everything above the £325,000 threshold to your spouse, civil partner, a charity or a community amateur sports club.

A life insurance payout into your estate can push its value over the threshold. Whether tax is then due depends on the rest of your estate, who inherits it and whether the policy is in trust.

By writing the policy in trust. A policy in trust isn't considered part of your estate, and MoneyHelper says it can then be paid outside probate and Inheritance Tax.

A trust can also speed up a claim. When you pass away, the payout goes straight to the people you've chosen, without waiting for probate (the legal right to deal with someone's estate).

In a trust, the settlor puts assets in, the trustees manage them and the beneficiaries benefit from them. The trustees are the legal owners of what the trust holds. For Inheritance Tax, HMRC normally treats a life policy in trust the same way as other trust property.

Trusts still have their own tax and registration rules:

• Premiums can count as gifts. If you pay the premiums on a policy someone else owns, such as trustees, they may be a potentially exempt transfer or a chargeable transfer for Inheritance Tax. That's after any exemption that's due.
• Regular payments are tax free with no limit if you can afford them after your usual living costs and pay them from your regular monthly income. This is called 'normal expenditure out of income'. In an HMRC example, £100 monthly premiums into a policy in trust for the policyholder's wife formed a pattern of giving, so they were exempt. Separately, the annual exemption lets you give away £3,000 of gifts each tax year without them being added to your estate.
• For most types of trust, Inheritance Tax is due when transfers into it total more than the £325,000 threshold. Trustees also pay a charge on every 10-year anniversary if the trust holds relevant property worth more than the threshold.
• A trust holding life insurance policies that only pay out on death, illness or disability doesn't need to be registered, unless it's liable to UK tax. That exclusion doesn't apply if the trust also holds a policy that doesn't meet those conditions, or any non-insurance assets.

• Life insurance in trust: how a trust works, the types of trust and how to set one up
• Life insurance beneficiary rules: who receives the payout if there is no trust

Yes. Inheritance Tax is usually paid from the estate's money, such as cash funds, a life insurance payout or the sale of property. MoneyHelper says life insurance can help your beneficiaries pay it without selling your home or other assets.

Executors must pay Inheritance Tax by the end of the sixth month to avoid interest. It usually has to be paid before they get probate. In England, with some exceptions, it's usually against the law to share out or take money from the estate before probate or letters of administration are granted.

A policy in trust isn't part of your estate, so its payout doesn't have to wait for probate. It can then cover a potential Inheritance Tax bill without adding to the estate's value.

Policies used for Inheritance Tax planning include:

• Whole of life insurance, which covers you for life and pays out when you die, as long as you keep paying the premiums. It's often used for Inheritance Tax planning. Our whole of life insurance calculator estimates the tax such a policy could be used to pay.
• Joint life, second death cover, which insures two people. At Royal London, it pays out after both have died or met its terminal illness definition. Its Personal Menu Plan offers it for Inheritance Tax planning. Inheritance Tax isn't normally due on what's left to a spouse or civil partner, and unused tax-free allowance can pass to them.
• Term insurance, which is often used to cover potential Inheritance Tax on large gifts made in the last 7 years. Gift inter vivos cover is a form of decreasing term cover for the tax that may be due if you die within 7 years of a gift.

Under the 7-year rule, there's no tax on gifts if you live for 7 years after giving them, unless the gift is part of a trust. If you die within 7 years and tax is due, gifts in the 3 years before death are taxed at 40%. Gifts made 3 to 7 years before death are taxed on a sliding scale called taper relief, from 32% down to 8%.

Taper relief only applies if the gifts made in the 7 years before death total more than the £325,000 threshold. Tax due on gifts is usually paid by the estate. If more than £325,000 was given away in those 7 years, anyone who received a gift in that time pays tax on it. The guide to how much you can gift tax free covers the allowances.

It's a 'chargeable event gain': a gain on a policy that's taxed as income, not as a capital gain. HMRC says the key distinction is between 'qualifying' policies, which usually don't give rise to a gain, and 'non-qualifying' ones, which often do.

A qualifying policy generally lasts at least 10 years, with fairly even premiums paid at regular intervals, such as weekly, monthly or yearly. Pure protection policies are left out of the annual premium limit for qualifying policies.

Non-qualifying policies are all policies that aren't qualifying ones. They're often single premium policies (paid for with one lump sum). A qualifying policy can still lead to a gain certificate. HMRC's examples include surrendering it or stopping premiums within the first 10 years, or breaching the £3,600 premium limit.

HMRC says a gain most commonly arises when:

• you receive cash or other benefits on a full or part surrender of a policy
• a policy matures or is brought to an end by the death of the person insured
• there is a sale or assignment of a UK policy, or part of a policy, for value

Some transfers don't create a gain at all. One is passing the policy to a spouse or civil partner you're not separated from. Others are using it as security for a debt, or transferring it for no money or money's worth, which includes gift assignments.

Because a gain isn't a capital gain, you can't set capital losses or the annual exempt amount against it. Tax at the basic rate may be treated as already paid on the gain. If so, only higher or additional rate taxpayers pay more, and tax treated as paid can't be repaid.

UK insurers must by law issue a certificate if they know a gain has been made on a life policy. So in most cases, if you've made a gain, you'll have received a certificate reporting it.

Critical illness cover, family income benefit and over 50s plans aren't taxed as income. Income protection paid for out of taxed income is generally tax free too.

Critical illness cover

Critical illness cover pays a tax-free lump sum. HMRC says it isn't taxable as income for the person who receives it, so no special exemption is needed.

The benefit can stay with you even when your life cover is in trust. Guardian's trust, for example, keeps any critical illness and terminal illness benefit for the policyholder. Once it's paid to you, the money is yours, and your estate is made up of your property, money and possessions.

Income protection

Since 6 April 1996, payments from policies that protect you against sickness, disability or unemployment have generally been tax free if the premiums came out of taxed income. There's no limit on how much you can receive tax free. That's one reason income protection usually pays a proportion of your income rather than all of it.

Cover through an employer works differently. Sick pay your employer funds, directly or through an insurance policy, is taxed as earnings. Under an employer's income protection scheme, sick pay is tax free only in proportion to your share of the premiums.

Family income benefit

Family income benefit is a type of term insurance that pays your dependants regular payments instead of a lump sum if you die. HMRC treats the payments as a series of capital sums on death, so they aren't treated as income.

Over 50s plans

Over 50s plans are guaranteed whole of life plans that pay a guaranteed tax-free lump sum when you die. Legal & General's Over 50s Fixed Life Insurance terms add that this cash sum will normally form part of your estate, so it may face Inheritance Tax.

Death in service and other cover from work

Employee packages often include death in service benefits, which give cover linked to your salary. Under the April 2027 pension changes, death in service benefits paid from a registered pension scheme stay outside Inheritance Tax.

Section 307 of the Income Tax (Earnings and Pensions) Act 2003 covers death or retirement benefits your employer provides. They aren't taxed under the residual benefits-in-kind charge, whether they come through a registered pension scheme or otherwise. For a relevant life plan, Royal London says HMRC doesn't treat the premiums your employer pays as a P11D benefit (a taxable perk your employer reports to HMRC).

• Critical illness cover: a lump sum if you are diagnosed with a serious illness
• Income protection: a monthly income while you can't work
• Family income benefit: regular payments to your family instead of a lump sum
• Over 50 life insurance

Start by checking whether your policy is in trust and what your estate is worth.

• Whether your policy is written in trust or has a nominated beneficiary. A policy in trust isn't treated as part of your estate. Without a trust or other arrangement, the payout normally goes into the estate.
• What your estate could be worth with the payout added. There's normally no Inheritance Tax below £325,000, and the standard rate above the threshold is 40%. The threshold can rise to £500,000 if you leave your home to children or grandchildren and the estate is worth less than £2 million.
• Whether a policy with a cash value is qualifying or non-qualifying. Your insurer can tell you, because it knows the details and history of the policy.
• Any chargeable event certificate from your insurer. UK insurers must by law issue one if they know a gain has been made on a life insurance policy.
• Legal and financial advice before setting up a trust or cover for Inheritance Tax. Aviva recommends it before putting a policy in trust, and says a trust can't simply be cancelled once it's set up. MoneyHelper suggests a solicitor or financial adviser for Inheritance Tax cover.