Putting Life Insurance in Trust: How to Avoid 40% Inheritance Tax and Probate
Our own mortality is not always something we like to think about.
However, to be responsible for the needs of our family, it is a subject which must be faced, especially in retirement.
Life insurance often presents a minefield of information and understanding all the options and legalities can be daunting.
What is sure is that we all want to leave our loved ones in the best financial position possible when we are no longer here.
This article will help you do just that.
What is Life Insurance and What Are the Benefits?
Life insurance offers a financial safety net for our loved ones should we no longer be around to provide. You set your cover amount (the sum assured), the policy length (the term) and pay a monthly fee (the premium) to receive the cover.
In recent times, the devastating impact of the COVID-19 pandemic has been a trigger for many to consider life insurance for the first time.
When in our 30s and 40s, life insurance is commonly taken out to cover significant debt like a mortgage (thus protecting the family home), as well as family living costs.
However, as we age our needs change and when we reach the retirement years it is more common to protect against things like rising funeral costs (average cost £4,271¹) or to leave an inheritance to grandchildren.
Inheritance Tax in the UK
Did you know that by default the proceeds from a life insurance payout form part of your estate and are therefore subject to inheritance tax (IHT)?
The current UK IHT threshold is £325,000², and you can earn up to this figure before being subject to tax. However, anything that exceeds this threshold is taxable at a hefty 40%.
Your estate is also made up of any property you own, possessions and savings. When you consider the current value of property, especially in certain regions of the UK, it is easy to see how the £325,000 threshold could easily be exceeded, resulting in paying a significant amount of tax.
However, there is a way of ensuring that a payout from your life insurance avoids forming part of your estate and therefore is not subject to IHT – and surprisingly it does not cost a penny.
Putting Life Insurance in Trust
If you write your life insurance in trust you detach it from your legal estate and as a result, the proceeds are not subject to IHT.
You effectively sign the rights to your life insurance over to a trustee/s to administer on your behalf, much like the executor of a Will. Therefore, it is important that you select a trustee/s (see below) who you fully trust to carry out your wishes.
As well as maximising the payout sum, writing your policy in trust can also ensure your loved ones receive the funds much faster, as they will not have to wait for probate to be granted (which on average takes between 6 – 9 months) before funds can be released.
Lastly, there is a third benefit from using a trust, allowing you greater control on how and when the proceeds are distributed.
For example, you wish for all your children to benefit equally from your life insurance, however, you may want to specify within the trust that they can only receive the funds after they turn 21.
Despite the above, at Reassured we estimate that only 6% of policyholders use this option, probably because they are simply not aware of the benefits.
A trustee must be over 18 and have a valid UK bank account. It is possible for a trustee to also be a beneficiary, and this is common within family trusts.
Where trustees are gifted discretionary rights, it may be advisable for there to be an independent trustee who would not benefit from the trust. Often, a policyholder will name their partner or children as trustee/s.
After you have passed away, the funds will be paid to the trustee/s to carry out your wishes.
Different Types of Trusts
It is important to understand that there are different types of trusts and the one you choose can affect the flexibility you have to make future changes.
1. Absolute Trusts (Sometimes Called Fixed trusts)
- You name the beneficiaries
- You decide how the payout is divided between the beneficiaries
- Your decisions cannot be changed at a later date
2. Flexible Trusts
- You name the default beneficiaries
- You can also name potential beneficiaries (like grandparents naming future grandchildren)
- The trustees can change the default beneficiaries
- The trustees can change the payout split between default and potential beneficiaries to meet your wishes
- Could be a good option if you think your circumstances may change
3. Discretionary Trusts
- The most flexible trust, as there are no named default beneficiaries
- You provide a list of potential beneficiaries but give trustees total discretion as to who will benefit and how much they'll receive
- A discretionary trust also allows the addition of potential beneficiaries
- However, you have no overall control over who receives the payout, which is determined by the trustees
- You can send a letter of wishes detailing how you would like the payout to be divided, but there is no legal obligation for the trustees to adhere
The past couple of years have demonstrated just how fragile life can be, highlighting the importance of having some form of financial protection.
We hope this article has provided some valuable information on how best to make the most of your selfless life insurance investment.
Whilst writing your life insurance in trust can provide significant benefits, this option will not always be suitable and please do not consider this article financial advice.
Author: Reassured - An award-winning life insurance broker who offer a free trust writing service to guide you through the application process and answer any questions.
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