Comprehensive Guide to Life Insurance and if the Payout Is Taxed

A life insurance payout is not normally subjected to income or capital gains tax, but it is worth checking the details when setting up a life insurance policy. The majority of policies are also “written in trust” which means that they are considered a separate legal entity from the deceased’s estate.

As a consequence, this should also protect a beneficiary from any potential inheritance tax liability.

Upon the death of a loved one, there will be many issues to consider, one of which may be financial security. Thankfully, life insurance policy payments can go a long way to bridging any income shortfall in the short to medium-term.

The fact that these payments are traditionally free of tax is a huge benefit. Keep reading and get a full comprehensive understanding of Life Insurance costs.

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What Life Insurance Payment Options Are There?

The two main life insurance payment options are a lump sum payment on death or regular payments which start on death. It may be that the beneficiary would prefer to have a regular stream of income as opposed to one lump sum payment - this is something that should be discussed before setting up a policy.

Obviously, the idea of a loved one dying is not easy to discuss, but these matters must be addressed, so there is no uncertainty or confusion.

Will I Pay Tax on a Lump Sum Payment After Death?

Normally a lump sum payment after death will be paid directly to the beneficiary, and in normal circumstances, there would be no income tax or capital gains tax to pay. If the life insurance policy is structured correctly, the beneficiary should also avoid any potential inheritance tax liability.

Will I Pay Tax on Regular After Death Life Insurance Payments?

As these payments are traditionally paid directly to a partner/family member (the beneficiary), there should be no income tax or capital gains tax liabilities. Where a life insurance policy payment is made to a third party, for example, a trust, the situation can become a little more complicated, and it is worth taking advice.

What Is “Writing the Policy in Trust”?

When setting up a life insurance policy, you will be given the option of writing the policy in trust. This effectively means that any payment from the policy is separate from the deceased’s estate and therefore not susceptible to inheritance tax.

This is one reason why it is very important to take financial advice when setting up a life insurance policy, naming beneficiaries and ensuring that you do not stumble blindly into a potential inheritance tax situation.

What if Death Benefits Are Paid Into a Trust?

If you have a trust named as the beneficiary on your life insurance policy, then payment after your death will be paid into the trust. Again, you would need to take financial advice because there may be scenarios where income tax and potentially inheritance tax liabilities could be created.

If done correctly, normally by writing the policy in trust, there should be no tax liabilities, but there are some exceptions to this rule.

Can I Use a Life Insurance Policy to Cover Future Inheritance Tax Liabilities?

In some circumstances, and again specific advice will be needed for your situation, it may be possible to take out a life insurance policy which could cover potential inheritance tax liabilities on the rest of your estate. This is a popular method of covering what can often be a significant tax liability which can eat away at funds/assets left for your beneficiaries.

Would I Pay Tax on Life Insurance Payment Interest?

There may be situations where the payment of a death benefit is delayed and interest accrued. This interest is treated separately to the initial death benefit payment, and you would likely need to pay income tax on the interest element.

What if I Receive More Than One Death Benefit Payment, Do I Pay Tax?

If for example, there are individual life insurance policies for your parents there is the potential to receive two death benefit payments in your lifetime. Assuming there are no complications, simple payments to you as the beneficiary should be free of both income tax and capital gains tax.

The situation can be a little more complicated when it comes to inheritance tax and payment of death benefits into a trust set up with you as a named beneficiary. These are scenarios where advice should be taken.

Do I Need to Take Financial Advice?

The immediate aftermath of the death of a loved one is challenging enough without having to worry about potential tax liabilities. Therefore, when looking to take out a life insurance policy, it is very important to take advice.

This advice should incorporate your combined finances, assets, liabilities and the relevant policies taken out to ensure that both parties are as supported/protected as much as possible in the event of the other’s demise.

Should I Review My Life Insurance Policies on a Regular Basis?

Depending upon which type of life insurance policy you choose, you will have a set term, or it may be open-ended. There is certainly nothing wrong in reviewing your life policies in tandem with your financial affairs on a regular basis.

If for example, you have come into a particularly large windfall, it may be sensible to increase your life insurance payment to assist with any potential tax liabilities in the future.

Are Life Insurance Premiums Tax-Deductible?

The whole idea of life insurance cover is to provide as much money as possible for beneficiaries after your death. If life insurance premiums were tax-deductible then, in theory, the taxman would seek a portion of any eventual payout.

There may be situations where life insurance cover is taken out by a company, and any payment could be susceptible to tax. As a consequence, it may also be possible to deduct life insurance premiums against business income.

This is an even more technical area of life insurance and one which should be avoided at all costs without specialist professional advice.

Do All Employers Offer Death-in-Service Cover?

No. This is not a legal requirement for employers, but many will offer death-in-service life insurance cover. This means that if you were to die, in the workplace or out of the workplace, while in employment, then your employer’s death-in-service life insurance cover would payout. This is often used as a means to attract high-calibre employees and is something that you should mention when looking to change employment.

Is Employer Life-Insurance Taxable?

Interestingly, while the tax authorities seem to see everything as a “benefit in kind”, death-in-service life insurance cover is not viewed in this way, as a consequence, there are not normally any taxation issues with regards to death in service cover. This may change if the government were to adjust current tax regulations, but at this moment in time, the death-in-service cover is not seen as a “benefit in kind”.

What Is the Average Death-in-Service Cover Payment?

There is no figure set in stone, but you tend to find that death-in-service life insurance cover is between three and five times your annual salary. Obviously, this can be a very useful financial benefit for those left behind in the event of your death.

Do I Need Personal Life Insurance Cover if I Have Death in Service Cover?

This is a very interesting question which would need advice for your particular situation. For example, your death-in-service cover only covers the period during which you are employed by a specific employer. If you were to leave your role within the company, then the death-in-service cover would end immediately.

It may be that your new employer does not offer death in service, at which point you would need to consider personal life insurance. This leads onto the issue of affordability, premiums and how your life insurance payment would be used upon your demise.

Can I Choose My Death-in-Service Beneficiary?

Yes. You have the option of choosing the beneficiary of any death-in-service payment although traditionally this would be your partner/family. However, this is an area which can get relatively complicated.

If an individual was financially dependent on you, but not named as your beneficiary, they may have a case to overturn your chosen beneficiary on your death. These issues are never straightforward, and you should seek financial advice if you are thinking along these lines.

Will I Need to Adjust My Life Insurance Cover Going Forward?

There are numerous reasons why you may take out life insurance, simple financial assistance for your loved ones or to cover existing debts such as a mortgage. What you will find is that a life insurance strategy from 10 years ago may not be wholly appropriate for your situation today and future prospects.

It is therefore advisable to review and adjust your life insurance cover as and when required. We are not suggesting you should adjust this cover annually, but if there is a significant change in your financial/personal situation, it is something to consider.

As mentioned above, life insurance, whether personal life insurance or death-in-service life insurance should be considered in tandem with your financial affairs each year.

Summary

As long as your life insurance policy is relatively straightforward, all payments are covered, and beneficiary details are up to date then you should not incur any additional tax liabilities. As most policies are “written in trust” this offers a further degree of protection, but you should ask the question all the same.

How Can Money Savings Advice Help You With Life Insurance?

Here at Money Savings Advice, we have partnered with some of the UK’s leading Life Insurance brokers. They have already helped thousands of people get the best Life Insurance cover and they can do the same for you.

Choosing an independent adviser means they won’t recommend a scheme unless they are sure it is in your best interests. Their advice is also regulated by the FCA, which gives you an additional layer of protection.

If you would like to speak to one of these brokers who can provide you with a ‘whole market quote’ then click on the below and answer the very simple questions.