Understanding Life Insurance Payouts and Inheritance Tax Exemptions in the UK
- TBA
- 13 hours ago
- 4 min read
If you think Inheritance Tax is something only the wealthy should worry about, it’s time to think again.
The UK’s Inheritance Tax system is undergoing major changes, and this ‘silent revolution’ could quietly reshape how every family passes on its wealth.
The story of Simon Broadbent
Simon Broadbent, an entrepreneur from Huddersfield who runs a 160-year-old metal forming company, recently decided to gift his estate to his descendants.
However, one issue deeply troubles him:
‘I am 83 next birthday and, so that my descendants escape the potential inheritance tax bill of £6m-plus, I’ll have to survive until October 2032. My firm is property-based. In the event of an earlier demise, sites will require disposal within six months, cruelly affecting investment, growth and employment. In my case the tax has turned into an ageist lottery. At the moment plans are afoot to rig up a life-support unit at home with an instruction to pull the plug on the appointed day, seven years hence.’
At his age, his concern is understandable.
Under current UK Inheritance Tax rules, if the person making the gift survives for at least seven years after transferring assets, the gift becomes completely tax-free. However, if the person dies within seven years, the gift is treated as part of their estate and taxed on a sliding scale depending on how many years they lived after the transfer.
So, for Simon, his most important task now is simply to keep living — while tallying up his assets: property, jewellery, savings, cash, and life insurance.
But this leads to one key question:
When the policyholder dies, does the life insurance payout count towards Inheritance Tax?
When is life insurance subject to Inheritance Tax?
Under current UK law, life insurance payouts are not automatically exempt from Inheritance Tax. Whether they are taxed depends entirely on how the policyholder and beneficiaries are arranged. The key factor is whether the payout forms part of the deceased’s estate.
The payout counts as part of the estate – Inheritance Tax applies
Scenario: You personally hold the policy and list your estate as the beneficiary (or fail to name a beneficiary).
Tax treatment: The payout becomes part of your estate and is added to other assets such as property and savings. If the total exceeds the Inheritance Tax threshold (£325,000, or up to £500,000 if left to direct descendants such as children or grandchildren), the excess is taxed at 40%.
The payout is excluded from the estate – Inheritance Tax avoided (most effective approach)
Scenario: You place your life insurance policy into a trust.
Tax treatment: The policy legally belongs to the trust rather than to you. When you pass away, the insurer pays the proceeds directly to the trust, which distributes them to your chosen beneficiaries. Because the funds never form part of your estate, they are usually exempt from Inheritance Tax and bypass probate entirely.
The payout goes to a spouse or civil partner – automatically tax-free
Scenario: You designate your spouse or civil partner as the sole beneficiary.
Tax treatment: Under UK law, transfers between spouses or civil partners who are UK-domiciled are completely free of Inheritance Tax, regardless of the amount.
Inheritance Tax reforms in 2025
As of 6 April 2025, the ‘domicile’ concept was abolished in favour of a residence-based approach.
Anyone who has been a UK tax resident for at least 10 of the previous 20 tax years will be treated as a ‘long-term resident’, meaning their worldwide assets (including overseas property and bank accounts) could be subject to UK Inheritance Tax.
Even after leaving the UK, their non-UK assets may remain taxable for up to 10 years, depending on how long they previously lived in the UK.
The government is tightening Inheritance Tax reliefs.
For instance, from April 2027, inherited pensions may become taxable, and reliefs for family business transfers are also under review. These developments highlight the growing importance of early tax planning.
How to plan ahead and avoid Inheritance Tax
Put your life insurance policy in trust
This is the most effective strategy. Once your policy is held by a trust, the payout is no longer part of your estate. It avoids probate and can be distributed immediately to your beneficiaries — free from Inheritance Tax.
Plan your finances early
Under the UK’s ‘seven-year rule’, any gifts you make during your lifetime are fully exempt if you survive for seven years after the gift.
Even if you die within seven years, the tax rate reduces gradually based on how long you lived. Many wealthy individuals use this rule to transfer wealth early and reduce future tax exposure.
Seek professional advice
Inheritance Tax and trust planning are complex. It’s highly recommended that you seek professional advice from an experienced accountant or tax lawyer to design the most efficient strategy for your personal and family circumstances.
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