Introduction: Why Income Protection Insurance Needs a Two-Country Review
Income protection insurance is the policy that replaces part of your earnings if illness or injury stops you working, and for an American earning £300,000 or more in London it is often the single largest insurance contract they own. In Britain the rules feel simple: buy a personal policy from taxed income and the monthly benefit arrives tax-free. However, the United States taxes its citizens on worldwide income, so the same policy must also be tested against the Internal Revenue Code, and the answers do not always match.
Furthermore, most American professionals in the City hold two layers of cover at once. Their employer provides group cover through a bank, law firm or fund, and they top it up with a personal policy because group schemes cap the benefit well below a senior salary. Each layer is taxed differently in each country. Consequently, a claim that HMRC treats as tax-free may be taxable in America, and a claim that the IRS ignores may be fully taxed through PAYE.
At TaxYork, we prepare US and UK returns for high-net-worth Americans in Britain, and income protection insurance sits on a surprising number of those returns. Usually it appears in two places: the year someone claims, and the years nobody noticed a 1% US excise tax on premiums paid to a British insurer. This guide covers both, with current 2026/27 figures and a worked case study.
Income Protection Insurance in Plain Terms
Income protection insurance pays a regular monthly benefit, usually 50% to 70% of gross earnings, after a deferred period of four, thirteen, twenty-six or fifty-two weeks. It continues until you recover, return to work, reach the policy end age or die. In the United States, the equivalent product is called disability income insurance, and the IRS treats both labels identically under the accident and health insurance rules.
Who Should Read This Guide
This guide is written for US citizens and green card holders living in the UK, including investment bankers, partners in professional firms, private equity professionals, surgeons and owner-directors of UK companies. It also helps Americans who bought income protection insurance in Britain and later moved back to the United States. If you have missed earlier filings, our US tax return preparation for expats service handles the catch-up work first.
How HMRC Taxes Income Protection Insurance Benefits
Britain exempts most personal income protection insurance benefits from income tax. Specifically, section 735 of the Income Tax (Trading and Other Income) Act 2005 exempts payments under a policy that insures against sickness, disability or unemployment, provided the conditions are met. HMRC's Insurance Policyholder Taxation Manual at IPTM6110 confirms there is no cap on the amount you can receive tax-free.
The Conditions for a Tax-Free UK Benefit
The exemption depends on four tests. First, you must not have received UK income tax relief on the premiums. Second, the policy must cover a qualifying health or employment risk. Third, the payment must relate to a qualifying period, which HMRC explains at IPTM6115: the illness, the recovery, a period out of work or a period of reduced income. Finally, the contract must be genuine insurance on arm's length terms.
Importantly, HMRC states that relief given abroad against a foreign tax does not disqualify a policy. Similarly, payments from a non-UK policy are treated in the same way as payments from a UK policy. Therefore, an American who kept a US disability policy after moving to London can usually receive the benefit free of UK income tax.
Group Schemes and Section 743 Apportionment
Group income protection insurance works differently because your employer, not you, owns the contract. As a result, the benefit reaches you through payroll and HMRC taxes it as employment income under PAYE. However, section 743 of ITTOIA 2005 exempts a "just and reasonable" part of the benefit where you contributed to the premiums from taxed income.
HMRC's guidance at IPTM6120 explains the practical effect. In short, sick pay is tax-free in proportion to the share of premiums you funded personally. Any part that fails the test is taxed as employment income in the ordinary way.
Salary Sacrifice: The UK Trap Most Employees Miss
Salary sacrifice changes the UK answer completely. Under the optional remuneration arrangement rules described at EIM21820, salary you give up in exchange for cover does not count as your contribution to the premiums. Instead, HMRC treats the funding as an employer contribution. Consequently, the whole benefit is taxable through PAYE, even though you effectively paid for the cover with your own salary.
How the IRS Taxes Income Protection Insurance
The United States reaches broadly similar answers through different code sections. Under Internal Revenue Code section 104(a)(3), amounts received through accident or health insurance for personal injuries or sickness are excluded from gross income. However, the exclusion does not cover amounts attributable to employer contributions that were not included in your income.
Personal Policies Paid From Taxed Income
For a personal policy that you pay for yourself, the US answer is clean. IRS Publication 525 confirms that if you paid the premiums on an accident or health policy, the benefits you receive are not taxable. Therefore, a personal income protection insurance benefit is normally tax-free in both countries, which is the ideal outcome.
Nevertheless, the trade-off is that you get no deduction for the premiums on either side of the Atlantic. Specifically, IRS Publication 502 excludes policies that pay for loss of earnings from deductible medical insurance. Similarly, the self-employed health insurance deduction covers medical care cover, not earnings replacement.
Employer-Paid Group Cover
Employer-paid income protection insurance follows a two-step rule. First, section 106 excludes the value of employer-provided accident and health coverage from your wages, so the premiums your London employer pays are not US taxable income. Then, section 105 taxes the benefits attributable to those employer contributions when you claim.
Notably, the section 106 exclusion is not limited to American employers. A UK bank's group scheme is an accident or health plan for US purposes, so you need not add the premium to your US wages each year. However, you must report the benefit when it is paid.
Contributory Plans and the Three-Year Ratio
Where you and your employer share the premium, the US splits the benefit. Treasury Regulation 1.105-1(d) taxes the portion that matches the employer's share of net premiums, generally measured over the last three policy years for which premiums are known. Accordingly, a plan where you funded 40% from taxed salary produces a benefit that is 40% excluded and 60% taxable.
The UK uses a "just and reasonable" apportionment instead. In practice, the two ratios usually land close together, but they are calculated differently. Therefore, you should obtain the insurer's or employer's premium history before you prepare the claim-year return.
Where the US and UK Treatment of Income Protection Insurance Diverges
The mismatches matter more than the general rules. In our experience, three situations create most of the cost, and none of them appears on the generic insurance guides that rank for this subject.
Salary Sacrifice: Taxed in Britain, Arguably Exempt in America
The first mismatch arises from salary sacrifice. As explained above, HMRC taxes the entire benefit because it treats sacrificed salary as employer money. By contrast, the United States has no equivalent of a British optional remuneration arrangement. A US salary reduction is respected only under a qualifying cafeteria plan, and a UK scheme is not one.
Accordingly, the stronger US reading is that the sacrificed salary remains part of your US wages. Publication 525 then supplies the answer: if premiums were included in your income, you are considered to have paid them, and the benefits are not taxable. Consequently, the same income protection insurance claim can be fully taxed in Britain and excluded in America. The UK tax then produces excess foreign tax credits rather than double tax, but only if both returns are prepared consistently.
Group Benefits: Taxed in Both Countries
The second situation is ordinary employer-paid income protection insurance. Here, both countries tax the benefit. Britain collects income tax through PAYE, and the IRS includes the same amount under section 105. Therefore, you rely on the foreign tax credit, claimed on Form 1116, to stop the income being taxed twice.
Furthermore, the benefit falls in the general category basket, alongside your salary. UK income tax at 40% and 45% normally exceeds the US tax on the same income, so the credit usually eliminates the US liability. In addition, any surplus UK tax carries forward for ten years, which helps later years with US-source investment income.
Why the Foreign Earned Income Exclusion Is the Wrong Tool
Many expats assume the foreign earned income exclusion will shelter a group benefit. However, the exclusion covers pay for personal services you actually perform. An insurer-funded benefit paid while you cannot work is not compensation for services in the year you receive it. Therefore, we treat these benefits as outside the exclusion and rely on the credit instead.
Moving Back to America While Claiming
Claims often outlast a London career. If you return to New York or California while still receiving benefits, the US treatment does not change: a personal policy remains excluded under section 104(a)(3), and an employer-funded benefit remains taxable under section 105. However, the UK position can shift once you become non-resident, because HMRC's right to tax a payroll benefit then depends on the employment it relates to and on the treaty.
Furthermore, state tax returns follow federal treatment in most states, so a tax-free personal income protection insurance benefit usually stays tax-free at state level too. Nevertheless, a taxable group benefit may then attract state income tax with no UK tax left to credit against it. Therefore, if you plan to move while a claim is running, model the year of departure before you book the flight.
Critical Illness Cover Sold Alongside Income Protection Insurance
Many advisers sell critical illness cover in the same application as income protection insurance, yet the two products pay out differently. Critical illness cover pays a single lump sum on diagnosis of a listed condition, rather than a monthly income. In Britain, that lump sum is not taxed as income. Similarly, in America it is generally excluded under section 104(a)(3) where you paid the premium from taxed income.
However, the excise tax analysis is identical for both products, because each is a sickness and accident policy. Consequently, if your insurer cannot rely on the treaty waiver, both premiums count towards the 1% charge. Equally, where an employer pays for critical illness cover, the lump sum follows the same section 105 rule as a group income benefit.
The 1% US Excise Tax on Income Protection Insurance Premiums
This is the reporting obligation almost every American in Britain has missed. Section 4371 imposes a federal excise tax of 1 cent per dollar of premium on policies of life, sickness and accident insurance issued by a foreign insurer. Moreover, section 4372 defines those policies by reference to risks of a United States citizen or resident, wherever that person lives.
Why a London Policy Can Fall Within the Tax
A British insurer that writes income protection insurance is a foreign insurer for US purposes. As a result, a personal income protection insurance policy covering a US citizen in London is, on the face of the statute, a sickness and accident policy within the excise tax. The tax is reported on Form 720 under IRS No. 30. The Form 720 instructions place the filing duty on the person who pays the premium, and on the insured if the payer does not file.
The excise sums involved are modest for most income protection insurance policies. For example, a £6,000 annual premium converts to roughly $8,100, so the excise tax is about $81 a year. Nevertheless, an unfiled quarterly return keeps the assessment period open, and the cumulative position grows quietly over a decade of renewals.
The Treaty Waiver in Article 7(5)
The US-UK income tax treaty contains an important relief. The treaty's Article 2 and Article 7(5) bring the federal excise tax on foreign insurers within its scope. Specifically, Article 7(5) states that the excise tax shall not be imposed on policies whose premiums are receipts of an insurance business carried on by a UK enterprise. However, the waiver does not apply to conduit arrangements, where the risk is reinsured with a person not entitled to similar treaty relief.
Accordingly, cover written directly by a UK-resident insurer that qualifies under the treaty's limitation on benefits article is usually outside the tax. By contrast, a policy issued by an offshore insurer in Guernsey, the Isle of Man or Dublin is not a UK enterprise and needs a separate analysis. Ireland, for instance, has its own treaty, while the Crown Dependencies have none.
Documenting the Waiver Properly
Because the treaty relief belongs to the insurer's receipts, you should not simply assume it applies. Instead, ask the insurer to confirm in writing that it is a UK-resident company carrying on an insurance business, that it qualifies for treaty benefits and that the risk is not reinsured under a conduit arrangement. Many large UK insurers hold closing agreements with the IRS for this purpose.
Where a treaty position overrides the Code, disclosure may also be needed on Form 8833. In practice, we keep the insurer's confirmation on file and pay the 1% where the insurer cannot provide it. The tax is small, while a clean file is valuable if your returns are ever reviewed.
FBAR, Form 8938 and Missed Reporting on Income Protection Insurance
Clients often ask whether British income protection insurance belongs on their foreign account disclosures. The answer depends on whether the contract has a cash value.
Why Pure Protection Policies Are Usually Not Reportable
Standard income protection insurance has no surrender value. It pays only if you claim, and it lapses if you stop paying. Consequently, it is not a financial account for the FBAR filed with FinCEN, and it is not a specified foreign financial asset on Form 8938. The IRS comparison of Form 8938 and FBAR requirements lists foreign insurance contracts with a cash value as reportable, which a pure protection policy is not.
When Bundled Policies Change the Answer
However, some UK contracts combine protection with an investment element. Whole-of-life policies, older unit-linked plans and certain executive packages carry a surrender value, which can make them reportable on both forms. Furthermore, an investment-linked wrapper may raise passive foreign investment company questions. Therefore, read the policy schedule rather than the marketing name before deciding. Our FBAR and FATCA reporting team reviews these contracts as part of every new engagement.
Correcting Missed Excise Tax Filings
If you have paid premiums to a non-treaty insurer for several years without filing Form 720, the fix is straightforward. You file the missed quarterly returns, pay the 1% tax with interest and attach a reasonable cause statement requesting penalty relief. Because the amounts are small, this rarely needs a formal disclosure programme. Nevertheless, you should correct it before filing any certification that your returns are complete.
Income Protection Insurance for UK Company Owners
Owner-directors face a separate set of choices. Many hold executive income protection insurance, where the company owns the policy, pays the premium and receives the benefit.
The UK Position for Executive Cover
In Britain, executive cover is usually deductible for corporation tax as a trading expense, and HMRC does not normally treat it as a taxable benefit in kind. The company then pays the benefit to you as salary, taxed through PAYE. Our guide to P11D benefits in kind on a US return explains how other employer-provided benefits are handled.
The US Position for a Controlled Foreign Corporation
On the US side, an American owner of a UK company usually owns a controlled foreign corporation. The premium is an employer contribution, so section 106 keeps it out of your wages. When you claim, the company receives the benefit and pays you salary, which is taxable wages for US purposes and creditable against UK PAYE.
Inside the company, the insurance receipt increases taxable profit, while the salary paid out reduces it. As a result, the net effect on tested income for the US inclusion regime is usually small. Similarly, we review key person insurance in a UK company, which follows comparable logic but protects the business rather than your personal income.
Personal Versus Company Ownership
For a high earner, personally owned income protection insurance often produces the cleaner result. You pay a premium from taxed income, and the benefit is then tax-free in both countries without a payroll charge. By contrast, company ownership saves corporation tax on the premium but converts every pound of benefit into taxable salary. Therefore, the right structure depends on your marginal rates, your US position and how long a claim might last.
Case Study: A London Banker Claims on Two Policies
The following illustrative example shows how the rules interact. The figures are rounded, use the 2026/27 UK bands and assume an exchange rate of $1.35 to the pound.
The Facts
Jordan is a US citizen working as a managing director at a London investment bank, with a base salary of £400,000. Jordan's employer provides group income protection insurance paying 45% of salary, which is £180,000 a year, paid through payroll after a twenty-six week deferred period. The employer pays the premium directly, without salary sacrifice.
In addition, Jordan bought a personal policy from a UK-resident insurer, paying £6,000 a year from taxed income. That policy pays £6,000 a month, which is £72,000 a year, after the same deferred period. In 2026, Jordan suffers a serious back injury and claims under both policies for a full year.
The UK Calculation
The personal benefit of £72,000 is exempt under section 735. By contrast, the group benefit of £180,000 is taxable employment income. Because Jordan's adjusted net income exceeds £125,140, the personal allowance is withdrawn entirely.
Accordingly, UK income tax is £7,540 at 20% on the first £37,700, £34,976 at 40% on the next £87,440 and £24,687 at 45% on the remaining £54,860. Total UK income tax is therefore £67,203, or roughly $90,700.
The US Calculation
On the US return, the personal benefit of about $97,200 is excluded under section 104(a)(3). The group benefit of about $243,000 is taxable under section 105. After the 2026 standard deduction, US tax on that amount is roughly $49,000 before credits.
Because the group benefit is UK-source general category income and the UK tax of $90,700 exceeds the US tax, the foreign tax credit eliminates the US liability. Furthermore, Jordan carries roughly $41,700 of unused credit forward. As a result, the claim year produces no US tax, and the excess credit shelters future UK salary once Jordan returns to work.
What Nearly Went Wrong
Jordan's previous preparer had treated both benefits as foreign earned income and claimed the exclusion. That approach would have been unsupportable for an insurer-funded benefit and would have wasted the carryforward credit. Moreover, nobody had checked whether the personal insurer qualified for the Article 7(5) waiver. In this case, the insurer confirmed its treaty status in writing, so no Form 720 was needed. Had it been an Isle of Man insurer, five years of 1% excise tax would have been outstanding.
How TaxYork Can Help
TaxYork prepares US and UK returns for high-net-worth Americans who hold income protection insurance through employers, personal policies and their own companies. Our team reviews your policy schedules, establishes who funded the premiums and applies the correct section 104, 105 and 106 treatment on the US return. At the same time, we confirm the HMRC position under sections 735 and 743.
Furthermore, we check every foreign insurer for Article 7(5) treaty status, file any outstanding Form 720 returns and keep a documented position for each policy. Where a claim creates excess UK tax, we model the foreign tax credit carryforward across future years. Our tax treaty optimisation service also covers the wider relief position, including pensions such as flexi-access drawdown if your illness leads to early retirement.
Conclusion
Income protection insurance is one of the few financial products where Britain and America reach similar headline answers, yet the details still diverge in ways that cost money. Personal policies paid from taxed income are generally tax-free in both countries. Employer-paid group benefits are taxed in both and need a foreign tax credit. Salary sacrifice schemes, however, are fully taxed by HMRC while arguably excluded by the IRS.
In addition, the 1% federal excise tax on foreign insurance premiums catches policies issued by insurers that cannot rely on the US-UK treaty. Therefore, review your cover before you claim, not after. A short review now settles the reporting, documents the treaty position and ensures your returns are prepared consistently if the worst happens.
Contact Us
If you hold income protection insurance in Britain, or you are already claiming, we can review your policies and prepare both returns correctly. Please contact us to arrange a confidential review. You can also email hello@taxyork.com or call 020 3488 8606 to speak with our US-UK tax specialists.
Disclaimer
This article provides general information about the US and UK tax treatment of income protection and disability insurance for Americans living in Britain. It does not constitute tax, legal, insurance or financial advice. Tax rules, rates, treaty positions and HMRC and IRS practice change frequently, and the correct treatment depends on your policy terms, premium funding and residence position. You should obtain professional advice before acting. TaxYork accepts no liability for action taken on the basis of this article alone.