How to make sure your life insurance pays out tax-free
Most people assume a life insurance payout is automatically tax-free. The payout itself usually is free of income tax and capital gains tax. The catch is inheritance tax, and whether it applies comes down to a few simple choices you make when you set the policy up. Get these right and your family keeps the full amount.
Step 1: Write the policy in trust
This is the single most important step. If a policy is not in trust, the payout is normally paid into your estate, added to everything else you own, and can be taxed at 40% if your estate is above the tax-free allowance (currently £325,000). Writing it in trust keeps the payout outside your estate, so it is not caught by that charge. Most insurers provide a trust form free when you take out the cover, so it usually costs nothing. You can often put an existing policy in trust too.
Step 2: Choose your trustees and beneficiaries with care
Trustees are the people who receive the payout and pass it on. Pick people you trust, such as your partner, a relative or a close friend, and it is wise to name more than one. Your beneficiaries are the people you want the money to reach. Keep these choices up to date, especially after big life events like marriage, divorce or a new child.
Step 3: Keep the policy valid
- Keep paying the premiums. If a policy lapses, there is nothing to pay out. Make sure the direct debit is reliable.
- Answer questions honestly when you apply. Insurers can refuse a claim if key information was wrong or left out, so be accurate about health, smoking and lifestyle.
- Review it over time. As your mortgage, family and income change, check the cover still matches what you need.
Step 4: Mind the couples trap
With a joint policy, the payout often goes to the surviving partner and becomes part of their estate, where it can be taxed when they die. Two single policies, each written in trust, can sometimes avoid that second-death tax. It is worth asking an adviser which suits your situation.
The one question to ask
When you buy or review cover, ask your broker or insurer plainly: "Can this be written in trust, and how do I do it?" That one question is what turns a payout that could lose 40% into one your family receives in full. An independent, FCA-regulated adviser, and often a solicitor for the trust, can set it up correctly.
Information only. This is general information, not financial, tax or legal advice, and not a personal recommendation. Tax rules depend on your circumstances and can change. Please speak to a qualified, FCA-regulated adviser or a solicitor before acting.