Is Income Protection Tax Deductible

Income protection insurance is designed to provide financial support if you are unable to work due to illness or injury. It pays out a regular income to help cover living expenses until you can return to work or reach retirement age, depending on the policy terms. With more individuals and businesses looking to manage financial risk, it’s natural to ask: is income protection tax deductible?

In the UK, the tax treatment of income protection policies depends on who takes out the policy, who pays the premiums, and who receives the benefit. The general rule is that income protection premiums are not tax deductible for individuals. However, limited companies may be able to claim relief in specific situations, though this comes with tax consequences when the benefit is paid.

This article explains the tax treatment of income protection policies for sole traders, employees, directors and companies, and what to consider when deciding how to structure your cover.

What Is Income Protection?

Income protection is a type of insurance that pays a percentage of your income if you are unable to work due to accident, illness or disability. It is different from:

• Life insurance (which pays a lump sum on death)

• Critical illness cover (which pays a lump sum on diagnosis of specific conditions)

• Payment protection insurance (which covers specific debts, such as loans or mortgages)

Most income protection policies pay between 50 and 70 percent of your pre-tax income after a waiting period (e.g. 4, 13 or 26 weeks). Payments continue until you return to work, retire or reach the maximum claim period.

These policies are widely used by self employed individuals and company directors who do not benefit from generous workplace sick pay.

Is Income Protection Tax Deductible for Individuals?

If you are self employed or a private individual, income protection premiums are generally not tax deductible. This applies even if the policy is essential for your financial security or helps you continue running your business.

HMRC views these premiums as personal protection, because the policy is designed to replace personal income, not protect business profits. The same rule applies whether you pay for the policy monthly or annually and regardless of whether the cover is linked to your professional role.

As a result:

• You cannot deduct the premiums as an expense on your Self Assessment tax return

• You must pay premiums from your post-tax income

• The benefit payments are tax free if you pay for the policy yourself

This tax-free status of the payout is important. Because no tax relief is given on the premiums, HMRC does not charge Income Tax on the benefits you receive if you claim.

Income Protection for Employees

If you are an employee and your employer provides income protection cover for you, the rules are different.

When your employer pays the premiums:

• The policy is usually treated as a taxable benefit in kind

• The cost of the premium is reported on your P11D or included in your payroll

• You pay Income Tax on the value of the benefit

• Your employer pays Class 1A National Insurance on the premium

However, if you receive a payout under the policy due to illness or injury, the income is taxed, as it is viewed as a continuation of employment income.

This is because you have received tax relief (indirectly) on the premium via your employer, so the payout is not exempt.

If the employer includes income protection in a wider group insurance scheme that covers many employees, and the policy is structured properly, the tax treatment may differ. For example, a group income protection scheme may result in the benefit being paid through payroll, subject to PAYE and National Insurance.

Income Protection Paid by a Limited Company

If you are a director or shareholder of a limited company, the company can take out and pay for an income protection policy on your behalf. The tax consequences depend on how the policy is structured and who receives the benefit.

There are two common approaches:

1. The company pays the premium, and the benefit is paid to the director
In this case:

• The premium is treated as a benefit in kind

• The company can deduct the premium from its Corporation Tax calculation

• The director is taxed on the benefit through payroll or P11D

• If a claim is made, the benefit is taxed as income

2. The director pays the premium personally
In this case:

• The premium is not deductible for Corporation Tax or personal tax

• There is no benefit in kind

• The benefit is paid tax free to the director if they cannot work

This second option may result in a higher up-front cost (as there is no tax relief on the premium), but the benefit is tax free. This can be a better financial outcome if the likelihood of a long-term claim is high.

Group Income Protection for Staff

Many larger companies offer group income protection as part of their benefits package. These policies are structured to:

• Cover multiple employees

• Provide a percentage of salary during illness

• Pay through the employer, subject to payroll taxes

The cost of group schemes is usually tax deductible for the employer, and the benefit is taxed as income to the employee. This makes the scheme relatively straightforward to administer and offers employees financial security without them needing to take out private cover.

Employers should still report the cost of providing this benefit and apply the correct PAYE treatment to any payments made during absence.

Business Protection vs Income Protection

It is important not to confuse income protection with business protection policies.

Business protection insurance is intended to cover:

• Loss of a key person

• Buy-sell agreements

• Repayment of business loans in the event of death or critical illness

Premiums for these types of policies may be tax deductible, but only if:

• The policy is designed to protect the business

• The business is the policyholder and beneficiary

• The policy is not linked to ownership or shareholding

Income protection, by contrast, is intended to replace individual income and is rarely allowable for tax relief unless it is structured as an employer-provided benefit.

Conclusion

Income protection premiums are not tax deductible for individuals or self employed workers in the UK. While you can still purchase a policy to safeguard your income, you must pay the premiums from post-tax income. The upside is that any benefit received is tax free.

Employers and limited companies can deduct the cost of income protection premiums, but this creates a taxable benefit for the employee or director, and any payouts received will be taxed as income.

Choosing how to structure your income protection cover is about more than just the premium. The tax treatment of the benefit is just as important and can affect your financial position if you ever need to claim. For this reason, it is wise to speak to both a financial adviser and accountant to ensure the policy fits your needs and is as tax efficient as possible.