Life insurance offers valuable protection for your loved ones. When you pass away, your beneficiaries could use the lump sum they receive to pay off the mortgage, cover living expenses or save for the future.
As a result, your family can maintain financial stability and continue working towards their long-term goals when you’re gone.
Unfortunately, many families are not able to retain all the wealth from a life insurance payout because they pay Inheritance Tax (IHT) on it – often unnecessarily.
Read on to learn why this is and how using a trust could help.
Nearly 7,000 families overpaid Inheritance Tax on wealth from a life insurance payout in 2021/22
When you pass away, your family may pay 40% IHT on the portion of your estate that exceeds a threshold known as the “nil-rate band”.
In the 2024/25 financial year, this is £325,000. You may also benefit from an additional “residence nil-rate band” of £175,000 when passing your main home to a direct descendant such as a child or grandchild.
Further to this, you can pass your entire estate to your spouse or civil partner without IHT, and they inherit your unused nil-rate bands. This means that you may be able to pass on as much as £1 million between you.
When you pass away, the executor of your Will must calculate the total value of your estate and apply the nil-rate bands. Your family may then pay IHT on any wealth that exceeds the threshold.
In some cases, the lump sum your family receives from your life insurance policy is included in your estate and, as a result, may be taxed.
According to the Actuarial Post, 6,810 of the 27,800 estates that paid IHT in 2021/22 included life insurance policies. The lump sums were worth a total of £819 million, meaning that families may have paid up to £327 million in IHT on wealth from life insurance payouts.
If your life insurance cover forms part of your estate for IHT purposes and you don’t write your policy in trust, your family may not have as much wealth to support them when you’re gone.
Your life insurance policy may not form part of your estate if you place it in trust
A trust is a legal arrangement that allows you (the “settlor”) to set assets aside for your “beneficiaries”. You then choose a “trustee” to manage the assets on your behalf until your beneficiaries receive them.
A life insurance policy can be placed in a trust, allowing you to name the beneficiaries who receive the payout.
There are several different types of trust that you may consider using, including:
- Absolute trusts – An absolute trust names beneficiaries who can’t be changed later.
- Discretionary trusts – Your trustees have more freedom to make decisions about who benefits after you pass away, which you can influence by naming a class of beneficiary or a letter of wishes to the trustees. The trustee may also be able to add more beneficiaries to the trust after you set it up.
- Survivors discretionary trust – This type of trust can be used for a joint life insurance policy with a partner. If one of you passes away, the surviving partner inherits the policy before any named beneficiaries. However, if both policy owners pass away within 30 days of one another, the named beneficiaries would inherit the lump sum.
When you put your life insurance policy in a trust, it’s normally considered outside of your estate for IHT purposes. This is because the lump sum is paid directly to the trust instead of becoming part of your estate and subsequently passing to your loved ones. The trustees can then distribute the funds to the beneficiaries, avoiding any IHT implications.
Another benefit of putting your life insurance in trust is that you could gain more control over who manages the lump sum from your policy and who benefits from the wealth.
Additionally, your family must normally go through the probate process to access the lump sum from a life insurance policy because they inherit it from your estate. Yet, when the life insurance policy is placed in a trust, your beneficiaries don’t need to do this. This means they could receive the lump sum much sooner than they would if it formed part of your estate.
That said, there are some potential downsides to consider before placing your life insurance policy in trust.
Once you place a life insurance policy in trust you can’t usually undo the decision
When you place your life insurance policy in trust, it technically belongs to your trustees. This can mean that it’s very difficult – or even impossible, in some cases – to make changes to the policy or the beneficiaries afterwards. This may be especially true if you use an absolute trust.
Depending on your life circumstances, this could cause problems. For instance, if you divorce and remarry, it may be difficult for your new partner to benefit from the life insurance policy.
There may still be some Inheritance Tax to pay on wealth from a life insurance policy
In many cases, putting a life insurance policy in a trust could mean that it doesn’t form part of your estate and your family won’t pay IHT on the lump sum they receive.
However, the process of creating and managing a trust can be complicated. That’s why it’s important to seek professional advice to ensure that you’re being as tax-efficient as possible and you are aware of any potential challenges.
Get in touch
If you’re concerned about the IHT your family may pay when you’re gone, we can advise you.
Email hello@fcadvice.co.uk or call 0333 241 9900.
Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
The Financial Conduct Authority does not regulate estate planning, tax planning, trusts, or Will writing.
Note that life insurance plans typically have no cash in value at any time and cover will cease at the end of the term. If premiums stop, then cover will lapse.
Cover is subject to terms and conditions and may have exclusions. Definitions of illnesses vary from product provider and will be explained within the policy documentation.
