Tax on protection payouts: income protection, life and critical illness

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Money paid out by a protection policy is, in most cases, tax-free in the hands of the person who receives it. Life insurance payouts are not subject to income tax or capital gains tax¹, and the same broad position applies to payouts from income protection and critical illness cover: the money arrives as a lump sum or a replacement income and no income tax is deducted from it as earnings would be.

The tax that can catch a life insurance payout is Inheritance Tax, and it catches the estate rather than the beneficiary. If a life policy is not written in trust, the payout will usually be treated as part of the estate when the policyholder dies², which means it is added to the value of everything they owned and measured against the tax-free allowance in the same way³. A large policy can be enough, on its own, to push an estate over the threshold and leave a 40% bill on the excess.

A life insurance payout can count as part of your estate

Inheritance Tax is a tax on the estate of someone who has died: their property, money and possessions¹⁰. A life insurance payout is not taxed when it is paid, but where the policy was not written in trust, the payout will usually be treated as part of that estate². In practice this means the sum assured is added to the house, savings and everything else the deceased owned, and the whole is measured against the tax-free threshold. If a policy was taken out to cover an interest-only mortgage or to provide for children, the payout can be the single largest item in the estate, and it is often what tips the total over the limit³.

The position is different if the policy was written in trust. In that case the payout usually sits outside the estate for Inheritance Tax purposes², and it is not counted as part of the estate for other purposes either: Social Security Scotland notes that a life insurance payout written in trust is not counted as part of the estate and would not go towards funeral expenses¹¹. The choice between trust and estate is therefore the single biggest tax decision attached to a life policy, and it is covered in full later in this page.

Inheritance Tax thresholds: £325,000 per person, up to £1m for couples

Every person has a nil-rate band of £325,000, the amount an estate can be worth before Inheritance Tax applies⁴. This figure has been set at £325,000 since 2010¹². For married couples and civil partners the position is better, because a surviving partner can inherit any allowance their deceased spouse did not use, giving them a higher threshold of up to £1,000,000 before Inheritance Tax applies¹³.

The £1m figure is built from three parts. Each partner has the £325,000 nil-rate band⁴. On top of that sits the residence nil-rate band, an additional £175,000 allowance available where a home the deceased lived in is left to direct descendants such as children or grandchildren⁵, which brings an individual's threshold to £500,000¹⁴. When the first partner dies without using their allowances, the survivor can inherit the unused portions, and a couple can potentially pass on up to £1m entirely tax-free⁵.

Two limits bite on the residence allowance. It only applies where someone dies after 6 April 2017 and leaves a property that they own, or co-own, to direct descendants¹⁵. And if the total estate is worth more than £2m, the extra allowance tapers off, falling by £1 for each £2 above that threshold¹², so very large estates can lose the £175,000 altogether.

Unmarried couples are treated very differently. Married couples and civil partners can pass on £1m inheritance tax-free, whereas unmarried couples cannot inherit each other's unused nil-rate bands, so each partner is limited to their own £500,000¹². Two people who live together but are not married or in a civil partnership therefore have roughly half the combined allowance of a married couple in the same financial position.

The Inheritance Tax rate: 40%, or 36% with charity giving

Above the allowance, the standard rate is 40%: everything above the £325,000 threshold is taxed at 40%¹⁵. On an estate of £500,000 with no residence allowance, that means 40% of the £175,000 above the nil-rate band.

There is one widely available reduction. If at least 10% of the net estate, the amount above the allowance, is left to charity in a will, the Inheritance Tax rate on the rest of the estate falls from 40% to 36%¹⁶. The charity must be a registered one⁷, and only donations in a will count: gifts made during the person's lifetime do not trigger the reduced rate¹⁷. Because the rate cut applies to the whole taxable estate, not just the remainder after the charitable gift, a legacy of slightly more than 10% can sometimes leave heirs better off overall than leaving the charity nothing¹⁸.

The 40% rate also applies to certain gifts made shortly before death. Gifts above the £325,000 allowance made in the three years before the donor died are taxed at 40%, with the rate stepping down for older gifts under taper relief, explained below¹².

Payouts left to a spouse or civil partner

Assets left to a spouse or civil partner are exempt from Inheritance Tax, provided both partners are domiciled in the UK¹⁹. A surviving spouse or civil partner never pays Inheritance Tax on anything left to them, regardless of the amount, as long as both were UK-domiciled²⁰. Where the entire estate is left to a surviving spouse or civil partner, there is no Inheritance Tax to pay¹³, and the same exemption covers estates left entirely to charity¹³.

This exemption is what makes the transferable allowance work: the first partner's allowance is unused because everything passed to the survivor tax-free, and it can then be carried forward¹⁹. It is also why the marital status of the people around a life policy matters so much. A payout left to a husband, wife or civil partner attracts no tax whatever its size²⁰. A payout left to an unmarried partner attracts none of that protection: unmarried partners cannot inherit each other's unused nil-rate bands, and partners do not inherit from one another tax-free¹².

One narrow exception continues for annuities. Joint-life annuities, which continue to pay a partner after the annuity holder dies, will still be exempt from Inheritance Tax²¹, and where the surviving partner is a spouse or civil partner the usual exemption would apply in any event²².

Writing a life policy in trust keeps it out of the estate

Writing a life insurance policy in trust is the main way to keep a payout out of the taxable estate. If the policy is written in trust, the payout will usually sit outside the estate for Inheritance Tax purposes², and the payout is usually exempt from Inheritance Tax altogether²³. Because the money is paid to the trustees for the beneficiaries rather than into the estate, the family does not need to go through probate to receive the insurance money¹, and the payout can be used to settle a bill quickly without waiting for probate²¹.

The trust route has practical as well as tax advantages. A payout held in trust is not available to pay the deceased's debts or funeral expenses in the way estate money is¹¹, which can be a drawback if the estate has bills to settle, but it does mean the money reaches the intended people directly and quickly. Whole-of-life policies in particular are often written into trust precisely so the eventual payout does not form part of the estate for tax purposes²⁰.

The dedicated guide to writing life insurance in trust explains how the paperwork is done, and the narrow page on life insurance and Inheritance Tax covers the question in more detail.

Gifts, premiums and the seven-year rule

Inheritance Tax also looks back at gifts made while the person was alive. No tax is due on gifts as long as the giver lives for seven years after making them²⁴. Most gifts to people made more than seven years before death are tax-free, though gifts to trusts and businesses are treated differently²⁵. If the giver dies within seven years, the gift may still be taken into account when the estate is taxed¹⁹, and a child might need to pay Inheritance Tax on gifts, including a gifted deposit, if the parent dies within seven years of handing over the money²⁶.

Life insurance premiums can themselves count as gifts. HMRC treats premiums paid by the policyholder themselves as a lifetime gift, usually covered by the annual £3,000 exemption or the gifts out of normal income exemption²⁴. Separate individual gifts of up to £250 per person are also allowed²⁶. In practice, monthly premiums paid out of regular income rarely build up into a tax problem, but large single premiums paid late in life could in principle be caught by the seven-year rule.

Where a gift made before death is taxable, taper relief reduces the bill the longer the giver survived:

The legislation behind these rules contains further refinements: under the Inheritance Tax Act 1984, a payment of a premium on a life insurance policy is not treated as normal expenditure if it was funded by an annuity purchased on the same life, unless the two were not associated operations²⁷.

Who pays the tax on a payout, and when it is due

Inheritance Tax is administered by the personal representative of the estate, the executor named in the will or an administrator if there is no will. The personal representative usually pays any Inheritance Tax due before giving the beneficiaries their inheritance²⁸. You do not usually owe any tax on an inheritance at the time you inherit it²⁸.

The deadline is tight: Inheritance Tax must be paid by the end of the sixth month after the person dies to avoid paying interest⁸, and the executor must pay within six months of the death¹⁵. You will normally have to start paying Inheritance Tax before probate is granted⁸, which is why families sometimes need to release money from the estate, or use a life policy written in trust, to pay the bill before the estate itself can be touched.

A beneficiary can become personally liable for Inheritance Tax in three situations: where the person who died gave them a gift in the seven years before they died, where their inheritance is put into a trust that does not or cannot pay, and where the personal representative could not or did not pay before the inheritance was received²⁸.

Instalments are sometimes available. Tax on certain assets may be paid by 10 annual instalments³⁰, and you can pay in instalments if the shares or securities allowed the deceased to control more than 50% of a company, or if you were given an asset qualifying for Agricultural Relief or Business Relief, land or buildings, part or all of a business, or shares or securities³¹. You can also pay in instalments if at least 20% of the total Inheritance Tax the estate owes is on assets that qualify, or if paying in one lump sum would cause financial difficulties³¹. The first instalment is due at the end of the sixth month after the death, with payments then due every year on that date, and you must say on form IHT400 if you want to pay this way³¹. The full tax and interest can be paid off at any time by writing to HMRC asking for a final assessment³¹.

If the tax is not paid on time, interest will be owed on the Inheritance Tax¹⁵, and after the six-month deadline you will be charged interest³². Penalties can also apply if valuations of the estate are not accurate¹⁴.

Unused pensions and death benefits are joining the estate

From 6 April 2027, unused pension funds and death benefits payable from a pension will be brought into a person's estate for Inheritance Tax purposes⁹. The change was legislated by the Finance Act 2026, which brings unused pension benefits and death benefits into a deceased person's estate for Inheritance Tax purposes³³. From that date, personal representatives will be liable to report and pay any Inheritance Tax due on unused pension funds or death benefits³⁴.

There are carve-outs. All death in service benefits payable from a registered pension scheme will be excluded from the value of the estate for Inheritance Tax purposes from 6 April 2027³⁵, which matters to anyone whose family's cover comes from a workplace scheme rather than a personal policy, as explained on the death in service page. Joint-life annuities remain exempt²¹, and any unauthorised payments made from a deceased member's pension fund will be in scope of Inheritance Tax³⁴.

The practical effect is that from April 2027 a family calculating whether a life payout tips an estate over the threshold will also have to count the deceased's untouched pension pot. Someone whose estate sits just under the £325,000 allowance in cash and property could find that an unused pension pushes the total over, with the life payout then taxed at 40% on the excess.

Frozen thresholds mean more estates will pay

The tax-free allowances are frozen until at least 2031²³, while house prices, pension pots and the value of money generally continue to grow. Freezing the nil-rate band and residence nil-rate band rather than raising them with inflation drags more estates into the net each year²³, and a life insurance payout that would once have been comfortably absorbed by the allowance can now be the item that takes an estate over it.

The pension changes add a further step. The government estimates that around 213,000 estates will include pension wealth in 2027-28, of which around 10,500 will face an Inheritance Tax bill they would not have done under the previous rules, and a further 38,500 estates are expected to pay more tax than they would have otherwise²⁹. More than three quarters of the estimated 213,000 estates annually with inherited pension wealth have no Inheritance Tax liability, and fewer than 10% of estates annually are forecast to have an Inheritance Tax liability in the coming years³⁴, so this remains a tax on a minority of estates, but a growing one.

Where the protection stops

The protections on this page have edges worth stating plainly. The spouse and civil partner exemption requires both partners to be domiciled in the UK¹⁹; unmarried partners get none of it¹². The residence nil-rate band requires a home left to direct descendants and is tapered away above £2m¹². The 36% charity rate requires a legacy in a will of at least 10% of the net estate to a registered charity¹⁶. Writing a policy in trust usually keeps the payout outside the estate, but the word is "usually": the treatment depends on the trust being set up correctly, and the guide to writing life insurance in trust covers what that involves.

For the family, the obligations fall on the personal representative: value the estate accurately, because inaccurate valuations can lead to penalties¹⁴; pay the tax by the end of the sixth month after the death or interest follows⁸; and pay before probate is granted in the normal course⁸. Beneficiaries are protected from a direct tax bill in most cases²⁸, but not where they received a gift within seven years, where a trust fails to pay, or where the personal representative did not pay before passing on the inheritance²⁸.

Free, impartial help is available. HMRC guidance covers valuing an estate and paying Inheritance Tax⁸, mygov.scot sets out Inheritance Tax support in Scotland, and charities including Age UK and Independent Age publish guidance on dealing with an estate after a death¹³. The wider rules on Inheritance Tax, allowances and gifts are covered in the tax section, and the different protection products themselves in the protection insurance guide.