Life Insurance and Inheritance Tax
Trust arrangements and tax implications for life insurance policies
Key Takeaways
- • Life insurance payouts can be subject to inheritance tax
- • Writing policies in trust can avoid inheritance tax liability
- • Trust arrangements must be set up during the policyholder's lifetime
- • Different trust types offer varying levels of flexibility and protection
How Life Insurance Affects Inheritance Tax
Life insurance policies can significantly impact inheritance tax calculations. Without proper planning, the payout from a life insurance policy may be added to your estate value, potentially pushing it over the inheritance tax threshold and creating an unexpected tax bill for your beneficiaries.
One-line rule: Included if payable to the estate; usually excluded if the policy is written in trust for beneficiaries. Report relevant policies on IHT410 with IHT400.
Estate vs trust
If a policy pays to the estate, the proceeds are part of the estate for IHT. If the policy is written in trust for named beneficiaries, the payout generally bypasses the estate and is usually outside IHT. Always check the policy wording and any trust deed.
Premiums that you pay regularly, out of income, without reducing your normal standard of living can be exempt under IHTA 1984 s.21 ("normal expenditure out of income").
What to keep: evidence of income, regularity (e.g., annual/monthly), and that you retained sufficient income for usual expenses.
If you transfer a policy (or place it into trust) but retain a benefit or control, the value can be pulled back into your estate under GWR. Watch for indirect gifts (e.g., paying premiums in a way that preserves a benefit). Take advice before changing ownership/benefit structure.
- • Policy payout forms part of your estate
- • May push estate over inheritance tax threshold
- • Beneficiaries may face unexpected tax bills
- • Payout may be delayed during probate
- • Policy payout outside of your estate
- • No inheritance tax on the payout
- • Faster payout to beneficiaries
- • Greater control over distribution
Gift inter vivos (decreasing term to cover 7-year IHT risk)
A gift inter vivos policy is a decreasing term life assurance designed to cover potential IHT if you die within 7 years of making a substantial gift (e.g., a PET). The sum assured typically reduces each year in line with the taper of potential tax on the gift.
Types of Life Insurance Trusts
Trust arrangements and tax implications for life insurance policies
Life Insurance and Inheritance Tax
Trust arrangements and tax implications for life insurance policies
Key Takeaways
- • Life insurance payouts can be subject to inheritance tax
- • Writing policies in trust can avoid inheritance tax liability
- • Trust arrangements must be set up during the policyholder's lifetime
- • Different trust types offer varying levels of flexibility and protection
How Life Insurance Affects Inheritance Tax
Life insurance policies can significantly impact inheritance tax calculations. Without proper planning, the payout from a life insurance policy may be added to your estate value, potentially pushing it over the inheritance tax threshold and creating an unexpected tax bill for your beneficiaries.
One-line rule: Included if payable to the estate; usually excluded if the policy is written in trust for beneficiaries. Report relevant policies on IHT410 with IHT400.
Estate vs trust
If a policy pays to the estate, the proceeds are part of the estate for IHT. If the policy is written in trust for named beneficiaries, the payout generally bypasses the estate and is usually outside IHT. Always check the policy wording and any trust deed.
Premiums that you pay regularly, out of income, without reducing your normal standard of living can be exempt under IHTA 1984 s.21 ("normal expenditure out of income").
What to keep: evidence of income, regularity (e.g., annual/monthly), and that you retained sufficient income for usual expenses.
If you transfer a policy (or place it into trust) but retain a benefit or control, the value can be pulled back into your estate under GWR. Watch for indirect gifts (e.g., paying premiums in a way that preserves a benefit). Take advice before changing ownership/benefit structure.
- • Policy payout forms part of your estate
- • May push estate over inheritance tax threshold
- • Beneficiaries may face unexpected tax bills
- • Payout may be delayed during probate
- • Policy payout outside of your estate
- • No inheritance tax on the payout
- • Faster payout to beneficiaries
- • Greater control over distribution
Gift inter vivos (decreasing term to cover 7-year IHT risk)
A gift inter vivos policy is a decreasing term life assurance designed to cover potential IHT if you die within 7 years of making a substantial gift (e.g., a PET). The sum assured typically reduces each year in line with the taper of potential tax on the gift.
Types of Life Insurance Trusts
There are several types of trusts you can use with life insurance policies, each offering different levels of flexibility and control:
The simplest form of trust where beneficiaries have an absolute right to the policy proceeds.
Advantages:
- • Simple to set up and administer
- • No ongoing trust tax obligations
- • Beneficiaries have clear legal rights
Disadvantages:
- • Cannot change beneficiaries once set
- • No flexibility in distribution
- • Beneficiaries can claim at 18
Provides trustees with discretion over how and when to distribute the policy proceeds among beneficiaries.
Advantages:
- • Maximum flexibility in distribution
- • Can add or remove beneficiaries
- • Protection from beneficiary creditors
- • Can consider changing circumstances
Disadvantages:
- • More complex administration
- • Potential trust tax charges
- • Trustees have significant responsibility
A hybrid approach that starts as an absolute trust but can be converted to discretionary if needed.
Advantages:
- • Combines simplicity with flexibility
- • Can adapt to changing circumstances
- • Lower initial complexity
Disadvantages:
- • May trigger trust tax charges if converted
- • Requires careful documentation
Setting Up a Life Insurance Trust
The process of setting up a life insurance trust must be completed during the policyholder's lifetime. Here's what's involved:
Choose Trust Type
Select the most appropriate trust structure for your circumstances
Complete Trust Deed
Legal document establishing the trust and naming trustees and beneficiaries
Assign Policy to Trust
Transfer ownership of the policy from yourself to the trustees
Notify Insurance Company
Inform your insurer of the trust arrangement and provide documentation
Tax Implications and Considerations
While trusts can provide inheritance tax benefits, there are other tax implications to consider:
- • Policy payout excluded from estate
- • No 40% inheritance tax on proceeds
- • Preserves nil rate band for other assets
- • Faster distribution to beneficiaries
- • Discretionary trusts may face periodic charges
- • Income tax on trust income
- • Capital gains tax implications
- • Potential gift tax on policy transfer
Common Scenarios and Examples
Situation: John has a £500,000 life insurance policy and an estate worth £400,000. Without a trust, his total estate would be £900,000.
Without Trust:
- Total estate: £900,000
- Inheritance tax threshold: £325,000
- Taxable amount: £575,000
- Inheritance tax (40%): £230,000
With Trust:
- Estate for tax: £400,000
- Inheritance tax threshold: £325,000
- Taxable amount: £75,000
- Inheritance tax (40%): £30,000
Tax saving: £200,000
Forms reference: IHT410 (life assurance & annuities) with IHT400 as the main return. Use IHT409 separately only where pensions are relevant.
Important Considerations
- • Trusts must be set up during the policyholder's lifetime
- • You cannot set up a trust after death
- • Professional advice is essential for complex situations
- • Regular review ensures the trust remains appropriate
- • Consider the needs and circumstances of all beneficiaries
Leaving policies not written in trust can inflate the estate and delay access to funds (probate). A suitable trust often allows faster access and keeps proceeds outside IHT, subject to correct setup.