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It is common for people to believe that death benefits from life insurance companies are not taxed. However, in reality governmental institutions do tax some life insurance contracts. A good way to avoid these taxes is to write the insurance policy in trust. Nevertheless, not all insurance companies present their customers with this kind of opportunity. As a result, it is important to be acquainted with taxation on life insurances for a couple of reason. First of all, knowledge allows the dependents to avoid unpleasant surprise after the death of the policyholder. Secondly, heavy taxation on life insurance contract can make the death benefit insufficient to cover all necessary financial costs and keep the earlier standard of living.
In United Kingdom life insurance contracts are usually tax-free. However, if the dependents are left with a lot of wealth and estate, inheritance taxes will be applied to the assets above certain threshold. At the moment the inheritance tax threshold is £325,000. Inheritance tax is set by the government and is subject to change after every couple years. For example, in 1986 inheritance tax threshold was only £71,000. This threshold is changed periodically because people are becoming wealthier and the money is depreciating every year because of inflation.
In order to understand how the inheritance tax is applied a simple example can be taken. For example, Ann is 69 years old and is not married. She has a house in the suburbs of London, “Apple” stocks worth £50,000 and a life insurance policy with a death benefit of £100,000. Real estate appraiser calculated that the market value of the house is £250,000. Ann wants to leave all her assets to her niece. The wealth is worth £400,000 in total and exceeds the threshold by £75,000. As a result, 40 % tax will be applied to her assets after Anne’s death. As a result, her niece will have to pay £30,000 in order to inherit the house, death benefit and stocks. Luckily, death benefit is paid in cash and the stocks are liquid assets. Consequently, Anne’s niece will not face any problems when she will be asked to pay the inheritance tax. However, if the assets are not liquid, a person may face problems when trying to find the money for the estate tax. This is a situation where life insurance is a very handy tool because the death benefit can be used for estate planning.
In 2007 the government introduced a new exception to the inheritance tax threshold called spouse and civil partner exemption. From that year people are allowed to transfer their unused inheritance tax threshold to their spouses or civil partners after the death. As a result, the inheritance tax threshold of the second partners increases and is fixed at £650,000. There is only one requirement to which the person receiving the wealth has to comply: the individual has to have a permanent registered living place inside United Kingdom. There are no restrictions how much assets the dying person can leave to his spouse or civil partner and the threshold is not eliminated even if the living partner gets remarried. Partner with increased threshold can leave his dependents assets worth up to £650,000 and be calm knowing that the government will not take a part of the wealth. In order to apply for this exemption executors or personal representatives of the partners need to contact “HM Revenue and Taxes” and present necessary documents and forms.
Some life insurance companies offer an investment element. Those people that are planning to buy these kinds of policies have to be aware of the fact that they will be required to pay income tax on the gains from the investment. Income and gains from the life insurance investment funds that are based in United Kingdom is taxed at 20 % even if the policyholder is not a taxpayer. However, the person does not have to pay the tax himself, because 20 % tax from the gains in deducted by the insurance company and transferred to the governmental institutions directly. What is more, if a person is a higher rate taxpayer and his policy is non-qualifying, than he will be asked to pay an extra 20 % as an income tax when life insurance policy is cashed-in or it matures.
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The full list of qualifying and non-qualifying life insurance contracts is provided by the governmental organizations. However, usually qualifying policies are investment policies that require to pay monthly or annual premiums. When this type of policy matures the person is not asked to pay for the proceeds of the policy. However, this does not mean that this policy is tax-free. The tax is paid by the insurance company and then deducted from the value of the fund every year. These taxes cannot be reclaimed. What is more, a qualifying policy becomes a non-qualifying if it is cashed during the first 10 years or before Â¾ time of the term has passed (whichever comes first).
Single premium investment bonds are considered as non-qualifying policies. The gains from this kind of polices are further taxed for the higher rate taxpayers after the policy is cashed out. The income from non-qualifying policy is added to the person’s yearly income and as a result is included in the tax bill. The person does not have to pay the basic-rate tax because it was already paid by the fund. However, the person will have to pay the government the difference between higher and basic tax rates. At the moment the basic rate is 20 % and the higher rate is 40 %.
In United Kingdom insurance providers are required to provide policyholder with a certificate that includes chargeable events. Information about the type of policy and the taxes that will have to be paid is written in the certificate. Big insurance carriers usually hire tax consultants and as a result often offer the individual those life insurance types that fits their taxation needs the best.