Inheritance Tax (IHT) made the headlines again recently after Rachel Reeves announced several changes to the levy in her Budget. You might be especially concerned about your pensions because they will be considered part of your estate for IHT purposes from April 2027 onwards.
This means that your family could be more likely to pay IHT on your estate in the future, so it’s more important than ever to find ways to mitigate the tax. You may have already considered options such as lifetime gifting, and we can support you with this.
However, life insurance is one area that many people overlook when preparing for a potential future tax liability.
Indeed, MoneyAge reports that of the 27,800 estates that paid IHT in 2021/22, 6,180 included life insurance policies. Crucially, had they planned ahead, these families may not have needed to pay IHT on that wealth. This is because, your life insurance policy typically no longer forms part of your estate for IHT purposes if you place it in a trust.
Read on to learn more.
Your family could pay 40% Inheritance Tax on a life insurance payout
When you pass away, the executor of your will must calculate whether there is any IHT to pay before they divide your estate among your beneficiaries.
In 2024/25, you can pass on up to £325,000 without triggering an IHT charge. This is your “nil-rate band”. You might also benefit from the “residence nil-rate band” of £175,000 when passing your main home to a direct descendant such as a child or grandchild.
You can also pass your entire estate to a spouse or civil partner without IHT, and they inherit your unused nil-rate bands. This means that you could potentially pass on up to £1 million between you.
The executor of your will adds up the total value of all taxable assets, and any portion of your estate that exceeds your nil-rate bands will usually be subject to 40% IHT.
Normally, if you have a life insurance policy outside of a trust, the funds are paid to your estate when you pass away. This means that the payout from your life insurance policy is included in the calculations, and your family could pay IHT on those funds. Consequently, they might lose a significant portion of wealth that could otherwise provide a valuable safety net for them after you’re gone.
Additionally, your beneficiaries will need to wait until any outstanding IHT is paid, and the probate process is complete before they inherit wealth – including life insurance payouts – from your estate. If there is a large IHT bill, it could be difficult for your beneficiaries to find the necessary funds to pay it.
Your life insurance policy no longer forms part of your estate if you place it in a trust
A trust is a legal arrangement that allows you to pass assets to another person for the benefit of a third party.
When you place your life insurance policy in a trust, you hand it over to a “trustee”, so it’s no longer part of your estate. The trustee then manages it on behalf of the “beneficiaries” – the individuals who will eventually benefit from the life insurance policy when you pass away.
The payout from a life insurance policy goes directly to the beneficiaries and never forms part of your estate. As such, this wealth is not included in IHT calculations. Plus, your family doesn’t have to wait until the probate process is complete before they receive the funds.
As such, placing life insurance in a trust could mean that your loved ones retain the full amount and can access the funds sooner. If there is IHT to pay, your beneficiaries could use the wealth from your life insurance policy to help cover the bill.
There are several different types of trusts you could consider:
- Discretionary trust – This is a flexible option that gives the trustees power to choose the beneficiaries. For instance, when you pass away, they can decide how to divide the funds between your spouse, children and grandchildren, or other beneficiaries.
- Absolute or “bare” trust – This is a far less flexible option as you must choose beneficiaries when setting up the trust and they can’t be changed later.
- Survivor’s discretionary trust – This type of trust is most suited to joint life insurance policies. If one person passes away, the surviving member on the policy receives the payout in 30 days. However, if the surviving person also passes away within 30 days, the beneficiaries of the trust receive the funds.
Each type of trust has its own benefits and drawbacks, so it’s important to consider your own personal situation and chosen beneficiaries when deciding which option is right for you. You may also benefit from seeking professional advice as trusts can be very complex.
It’s important to consider the potential disadvantages of putting your life insurance policy in a trust
Placing your life insurance policy in a trust could help you reduce the IHT that your family pays when you’re gone. It might also mean that they can access the funds right away and potentially use them to cover an IHT bill, if necessary.
Despite this, there are some potential disadvantages to consider. Once you decide to put your policy in a trust, you can’t reverse your decision. Unless you use a discretionary trust, you might not be able to make changes to the policy either, and this could cause complications.
For instance, if you name your partner as a beneficiary and then separate, they will still receive a payout from your life insurance policy. Alternatively, you might have named children from a previous relationship but won’t be able to add children that you have after placing the policy in a trust.
You may have more flexibility if you use a discretionary trust, but all trustees must agree to any changes. Consequently, any disagreements might make it more difficult to alter your life insurance policy.
To avoid these issues, you may want to seek professional advice and consider potential challenges before putting your life insurance policy in a trust.
Get in touch
We can help you explore ways to reduce the IHT that your family pays in the future.
Please get in touch or email us at advice@mlifa.co.uk for more information.
Please note
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
All information is correct at the time of writing and is subject to change in the future.
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, or trusts.