A life insurance payout is usually tax-free — but whether it is subject to Inheritance Tax depends on one critical factor: whether the policy is written in trust. Understanding this distinction could save your family hundreds of thousands of pounds. Here is the complete guide for 2026/27.
The Two Taxes to Consider
| Tax | Does it apply to life insurance? |
|---|---|
| Income Tax | No — death payouts are income tax-free in the UK |
| Inheritance Tax | Depends — only if the policy forms part of your estate |
| Capital Gains Tax | No — life insurance policies are exempt from CGT |
Income Tax: Never an Issue on Death Payouts
A straightforward life insurance term policy paid out on death is not subject to Income Tax. The beneficiaries receive the full sum assured without any income tax deduction.
This applies to:
- Level term life insurance (fixed payout)
- Decreasing term insurance (used with mortgages)
- Whole-of-life policies paid out on death
- Critical illness cover payouts (also tax-free)
Inheritance Tax: The Critical Issue
This is where the real risk lies. A life insurance payout is subject to Inheritance Tax if the policy is not written in trust and the proceeds become part of the deceased’s estate.
Without a trust:
- Policy pays out → goes to estate → subject to IHT
- At 40% above the nil-rate band (£325,000 in 2026/27), a £500,000 payout could lose up to £70,000 in IHT (if the rest of the estate has already used the NRB)
With a trust:
- Policy pays out → goes directly to trustees → held for beneficiaries
- Bypasses the estate entirely — no IHT
- Also bypasses probate — funds typically available to the family more quickly
Worked example: The difference writing in trust makes
Alan has a £400,000 whole-of-life policy. His estate (without the policy) is already worth £750,000 — well above his nil-rate band of £325,000.
Not written in trust:
- Estate value including policy: £1,150,000
- IHT threshold (NRB only, no RNRB as no direct descendants): £325,000
- Taxable estate: £825,000
- IHT: £825,000 × 40% = £330,000
Written in trust:
- Estate value: £750,000 (policy not included)
- Taxable estate: £425,000
- IHT: £425,000 × 40% = £170,000
- Policy pays £400,000 direct to beneficiaries, IHT-free
- Saving: £160,000
How to Write a Policy in Trust
Most major insurers provide free trust forms. The process takes around 20 minutes and requires:
- Completing the insurer’s trust deed
- Nominating trustees (typically your spouse/partner plus another adult)
- Naming beneficiaries (or defining a class — e.g. “my children and their descendants”)
- Signing in the presence of a witness
No legal fees are required for simple absolute or discretionary trusts offered by insurers. Some people use a solicitor for more complex arrangements, particularly where the trust involves multiple policies or complex beneficiary classes.
Check existing policies: if you already have life insurance that is not in trust, contact your insurer — most allow you to assign the policy into trust retrospectively at no cost.
Discretionary vs Absolute Trust: Which to Choose
| Absolute trust | Discretionary trust | |
|---|---|---|
| Beneficiaries | Fixed — named individuals | Flexible — class of beneficiaries |
| Can trustees change distribution? | No | Yes |
| IHT treatment | Clean — outside estate | Outside estate; trustees have control |
| Best for | Simple, fixed beneficiary wishes | Future flexibility (e.g. grandchildren not yet born) |
Most couples use a discretionary trust because it allows flexibility — if a named beneficiary predeceases, the trustees can redirect the payout.
Chargeable Event Gains: The One Income Tax Risk
For whole-of-life policies with an investment element (investment bonds), surrendering or partially cashing in the policy can trigger a chargeable event gain — taxed as income in the year it occurs.
Key rules:
- 5% per year withdrawal allowance: you can take 5% of the original premium each year on a tax-deferred basis
- If withdrawals exceed the cumulative 5% allowance, the excess is a chargeable event gain
- On death, no chargeable event gain arises — the policy simply pays out income tax-free
For most people with standard term insurance, chargeable event gains are not relevant.
What About Group Life Insurance Through Work (Death in Service)?
Employer-provided group life (death in service) benefits are usually written in a discretionary trust by the employer for the benefit of employees’ families. This means:
- The payout does not form part of the employee’s estate
- No IHT is charged
- The employer has discretion over who receives the benefit — which is why a nomination form (Expression of Wishes) with your employer is important, even though it is not legally binding
Check with your HR department whether your employer’s scheme has an expression of wishes form — and make sure it is completed and up to date.
See our life insurance in trust guide, inheritance tax guide, and discretionary trust IHT explained.