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How much tax is deducted from life insurance?

How much tax is deducted from life insurance?

29 Sep 2020

Life insurance is often talked about as a tax-free lump sum that gets paid to your beneficiaries after you pass away, and this is true… up to a point.  However, even the great Benjamin Franklin himself said that “in this world, nothing can be said to be certain, except death and taxes”. Whilst many life insurance payouts are tax-free, there are a few situations where this isn’t true, and tax has to be paid. 

When is life insurance taxable? 

There are a few scenarios in which tax will be applied to a life insurance payout: 

  • If your policy includes an investment. This is known as a non-qualifying policy, and each situation will be different. Speak to a life insurance advisor and expert about your options here.
  • If interest has accumulated on the lump sum of the payout between the death of the policyholder and the transfer to the beneficiaries. 
  • If your estate is valued above £325,000 (or £650,000 if you’re married) or the life insurance payout pushes your estate value over this threshold. 
If any of these situations apply, the tax will fall to the beneficiary of the payout (the person you left the money to), so they will have to pay. 

In the first two situations, taxation may be unavoidable but the impact can possibly be lessened if you speak to an expert about your options. In the last situation, it’s possible to avoid taxation on your life insurance payout completely if you set up your life insurance payout to avoid inheritance tax. 

What is Inheritance tax?

When you pass away, your estate will transfer to a named beneficiary. The current inheritance tax (IHT) threshold is £325,000 per person, but it doubles to £650,000 for a married couple - as long as the first person to die leaves their entire estate to their partner. If the total of your estate is over £325,000, the government will charge a 40% levy on anything over this threshold. This is Inheritance Tax. 

Last year, the government collected a record amount of £5.2 billion in Inheritance Tax receipts from UK families estates alone. Your estate consists of all your assets, from houses to cars. All your cash and savings, plus personal effects are also included. On top of this is your pension and any life insurance policies. 

Any inheritance tax incurred must be paid by the end of the sixth month after the death of the person, or interest will then begin to be charged, which of course will increase the fee that needs to be paid. 

Your estate may not appear to be big enough to incur inheritance tax, but if your estate was valued at £310,000 and your beneficiaries then received a £15,000 payout from your life insurance, it would tip your estate over the threshold and inheritance tax would then be charged. 

How can I avoid paying inheritance tax for life insurance? 

Inheritance Tax isn’t always something you’ll be able to avoid, but there are ways to reduce the financial impact on the ones you love. If Inheritance Tax is something that you’re anticipating, you can dedicate a portion of your life insurance payout to pay off the tax bill. If your estate is below the threshold then of course you won’t have to pay, but you also won’t have to pay if you leave everything above the threshold to an exempt beneficiary, such as a charity. 

However, there are ways you can protect your life insurance payout from being subject to tax (or protect your whole estate from taxation if the life insurance payout is what tips your estate over the value threshold). Usually, the payout from a life insurance policy will form part of your legal estate. Writing your life insurance “in trust” will stop this. It doesn’t cost anything extra, and you can do it when you take out your policy. 

Writing your life insurance policy in trust basically means that the payout is paid to your beneficiaries and not to your legal estate. This will help to avoid your estate going over the Inheritance Tax threshold because it won’t be taken into account when Inheritance Tax is calculated.

Writing your policy in trust also means the probate process can be finished quickly and easily. Probate is a legal proceeding that confirms the executor’s authority to deal with the possessions in the will. This can take a while, but if the life insurance policy is in trust, the money can be released even before probate is granted. 

If you’re worried about tax on your life insurance, chat to us here at LifeSearch when you come to buy your policy, and we can help you get the right policy for you so that you don’t have to sacrifice assets you’ve worked hard for.  The Trust Team here at LifeSearch is here to help: we offer clients a free arrangement of their policy. Our service is simple and straightforward.

You might have a few questions and queries about this decision. Feel free to give us a call to speak to one of our LifeSearch advisers to learn more about writing your policy in trust on 0800 316 7253.

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