Tax exemption for sickness or unemployment insurance payments

Contents

This guidance tells you about a special tax exemption for payments made under some insurance policies in times of unemployment, sickness, disability, infirmity, or when there is a need for long-term care.

Further information may be found in the Inland Revenue’s Assessment Procedures Manual (AP1032 to AP1041).

You may have taken out insurance to pay particular bills, or to provide you with cash if you become sick or unemployed. In many cases, there is no tax to pay on benefits received under these types of insurance policies. This guidance tells you:

  • about this tax exemption
  • what sort of benefits are not exempt
  • what happens if you receive benefits because your employer has taken out this kind of policy, and
  • what you need to put in your tax return.

The word 'benefits' in this document means amounts paid out under an insurance policy.

The word 'sickness' also means disability, infirmity and the need for long-term care.

Life insurance and similar policies

This guidance does not cover life insurance policies, capital redemption policies or life annuities. Life insurance provides financial protection if you die, but many policies are also investments so they have their own special tax rules. Capital redemption policies are a special type of investment policy. Life annuities provide income whether or not you are sick or unemployed.

Your Inland Revenue office will be able to help if you want to know about the taxation of life insurance policies, capital redemption policies and life annuities.

Even if your policy is called life insurance or critical illness insurance it may also pay regular sickness benefits if you are ill. If your policy provides more than one type of insurance, for example, life insurance and sickness cover, see question 4.

General information

1. What types of policies pay benefits that may be tax free?

The most common types of policies that pay benefits that may be tax free are:

  • permanent health, personal accident, sickness or income protection insurances: these provide continuing income in times
  • sickness
  • some long-term care insurances: these provide benefits to meet the costs of residential care or care in the home
  • creditor insurance: benefits provided under this type of policy meet specific bills or debts. Examples are mortgage payment protection insurance, and policies to meet loan repayments or gas, electricity, water or credit card bills when you are sick or unemployed.

The answers to questions 12-16 tell you when benefits from these types of policy are not tax free.

2. Are similar benefits paid by friendly societies tax free?

Yes. The words 'policy' and 'insurance' in this document apply to cover provided through membership of a friendly society.

3. Can payments under joint policies be tax free?

Yes. Policies which pay benefits if your husband or wife becomes sick or unemployed, and those which cover people who are jointly responsible with you for a mortgage or other debt can come within the exemption.

4. My sickness and/or unemployment policy also provides other benefits. Can the sickness or unemployment payments be tax free?

Yes. The part of the policy providing sickness or unemployment benefits is treated as if it were entirely separate from the other part of the policy.

5. My policy continues to pay benefits after death or during convalescence or rehabilitation. Can these benefits be tax free?

Yes.

6. I have returned to work, but still receive insurance benefits because my pay is less than it was. Can these benefits be tax free?

Yes. Some policies pay benefits to top up earnings which are reduced following sickness or unemployment. These benefits can be tax free.

7. Is there a limit on the amount of tax free benefits?

No

8. Have my benefits always been tax free?

Benefits paid under creditor insurance (see question 1) are tax free whenever they were paid. For all other types of policy, benefits paid after 5 April 1996 are tax free.

9. Must I pay the premiums myself?

No, but see questions 17 and 18 if your employer, or former employer, paid for your premiums.

10. My insurer has offered me a lump sum to give up the right to future benefits. Is this tax free?

There is no tax to pay on this sort of lump sum unless:

  • benefits are paid under an employer's or former employer's scheme and you did not pay the premiums, or pay tax on the premiums, that relate to your benefits, or
  • the policy would have paid out a sum on death, or is a life annuity or a capital redemption policy.

Ask your Inland Revenue office for help if you are not sure whether or not your lump sum is taxable.

11. My policy pays a lump sum if I have an accident. Is this taxable?

Your lump sum will be tax free unless it falls within the categories listed in question 10. Even if it does, there are special rules that exempt many of these lump sums from tax. Your Inland Revenue office will be able to tell you about these rules.

Benefits that are not tax free

12. When are benefits paid in times of sickness or unemployment not tax free?

Benefits are not tax free if:

  • the policy under which they are paid does not meet certain conditions (see question 13)
  • they are business receipts (see question 14)
  • they fall within special rules that prevent abuse of the exemption (see question 15)
  • they are paid under an insurance scheme funded by an employer (see questions 17-20).

13. What are the main conditions a policy has to satisfy?

The main conditions are:

  • when it is taken out, the policy must provide insurance to cover future sickness and/or unemployment, or a deterioration in an existing medical condition
  • benefits must be paid only during periods of sickness or unemployment (but see questions 5 and 6 for exceptions to this rule).

14. When are insurance benefits 'business' receipts?

When the premiums are a tax deductible business expense. Ask your Inland Revenue office if you are not sure if your benefits are business receipts.

15. What are the special rules that prevent abuse of the exemption?

There are three main rules:

  • Benefits are not tax free when they are paid under the types of policy that cannot pay out significantly more than the premiums paid in, plus investment return.
  • Benefits are not tax free if some or all of the premiums have qualified for tax relief. For example, benefits paid under a pension plan where the contributions qualified for income tax relief are not within the exemption.
  • Benefits are not tax free where value has been transferred from one insurance policy to another, or between different aspects of a multi-benefit policy, so that benefits paid out are greater than they would otherwise have been. For example, if you have sickness insurance and a pension plan, you cannot arrange to pay less than you would normally pay for the sickness cover by agreeing to pay more for the pension plan.

Ask your insurer or Inland Revenue office for advice if you think that any of these rules may apply to you.

16. What types of long-term care insurance benefits are not tax free?

Long-term care insurance is a name used to describe many different types of insurance which provide for the cost of long-term care. Some are life insurance policies or are life annuities which have their own special tax rules, as explained at the beginning of this document. Others do not meet the conditions set out in question 13 because they are not taken out before the need for care arises.

If long-term care insurance benefits are not within this exemption, it does not necessarily mean that the benefits are taxable. Some policies are designed in such a way that the benefits do not count as the insured person's income for tax purposes anyway and, for other reasons, benefits paid under life insurance policies may not be taxable.

Ask your insurer or Inland Revenue office for advice if you are not sure if your long-term care benefits are taxable.

Employer's schemes

17. Are the benefits paid to me under my employer's insurance scheme taxable?

Yes. Benefits that come to you from an employer's scheme are treated as part of your earnings, and are taxed in the normal way (but see questions 19 and 20 if you contributed to, or were taxed on, your employer's premiums).

18. I retired through ill-health and receive continuing benefits because of my former employer's scheme. Are my benefits taxable?

Yes. You may be receiving benefits directly from an insurer under a 'new' policy written in your name. These benefits are also liable to tax. This is because your 'new' policy is linked to the policy paid for by your former employer.

If you contributed to, or were taxed on, your former employer's premiums, see questions 19 and 20.

19. My employer, or former employer, has an insurance scheme, but I contribute towards the premiums. Are my benefits tax free?

If you paid a proportion of the premiums that relate to you under your employer's scheme, the same proportion of any benefits which you receive will be tax free. So, if you paid one quarter of the premiums, one quarter of your benefits will be tax free, and three quarters will be taxable. This also applies if you continue to receive benefits after you have left the employment.

If you receive your benefits directly from an insurer because you left the employment, an insurer might deduct tax at the basic rate from the amount paid to you. This is because the insurer will not know that you contributed towards the premiums paid by your employer. If this happens, tell the insurer that you contributed to the premiums and ask for form R91 'Application for payments of benefits without deduction of tax'. The insurer will make arrangements to pay your benefits without deducting any tax and repay any tax deducted that was not due.

You must tell your Inland Revenue office about the portion of your benefits which is taxable and if an insurer makes a repayment to you.

20. My employer paid the insurance premiums, but I paid tax on the cost of the premiums. Are my benefits tax free?

Yes. Your benefits will be exempt because, effectively, you paid the premiums out of your taxed income.

21. My benefits are taxable and tax is deducted at the basic rate. Is this the final amount of tax that I must pay?

Not necessarily. You will have to pay additional tax if you are liable at higher rates of tax when your insurance benefits are added to the rest of your income.

You may be able to claim a repayment of tax if :

  • you do not pay tax because your taxable income (including any insurance benefits) is completely covered by your tax allowances, or
  • you pay tax at less than the basic rate, or
  • the amount of your income which is taxed at the basic rate is less than the amount of your insurance benefits.

Your Inland Revenue office will tell you how to claim any repayment of tax. If you do not pay tax because your taxable income is completely covered by your tax allowances, ask the insurer for form R91. The insurer may be able to pay your benefits without deducting any tax to save you the trouble of reclaiming it from the Inland Revenue.

Tax returns

You must tell your Inland Revenue office if you receive any insurance benefits which are taxable. If you receive a tax return, you should include in it the amount of your benefits which are taxable, even if the insurer has deducted the basic rate of tax from your benefits.

If you do not receive a tax return, but are liable to tax, write and tell your Inland Revenue office about your benefits.

Any further questions?

This guidance may not cover all your queries, so if you have any further questions, please contact your Inland Revenue office or Enquiry Centre.

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