How life insurance and trusts can reduce your inheritance tax liability

Why take out a life insurance policy?

Life insurance policies are often a key consideration for high net worth individual’s (HNWI) wealth and tax planning. They are designed to pay out a lump sum on the death of the life assured. The policy payout on death can be structured to provide the beneficiaries with the liquidity to cover all or part of the individual’s inheritance tax (IHT) liability on death, allowing their estate to remain intact and prevent the need for forced sales of any family assets.

One potential pitfall of the above is that the payout from a life insurance policy will, if left unmanaged, be paid out directly to the life insured. If so, this will be considered as part of their estate for IHT purposes. This means that the policy payout may be charged to IHT at 40% tax rate, creating a shortfall in the funds available to cover the overall IHT bill.

To avoid this occurring, a trust arrangement should be put in place to hold the policy and thus prevent the life insurance policy payout from becoming liable for IHT.

Why use a trust to hold a life insurance policy?

The amount of life insurance purchased will usually match an individual’s estimated IHT liability. This will be 40% of their estimated estate above their IHT free allowances.

The amount of the policy payable on death could be substantial and so it is important to avoid this sum falling back into the life insured’s estate on death, thereby compound their IHT liability and tapering any valuable reliefs.

This is where the use of a trust becomes important. By utilising a trust, the payout from an insurance policy is ringfenced from the rest of an individual’s estate. This ensures that, on their death, the policy proceeds are received by the beneficiaries of the trust who can then use the cash to pay the deceased’s IHT bill.

Furthermore, by passing the policy proceeds directly to the beneficiaries, the beneficiaries will receive the inheritance without the need to obtain probate. This reduces the timeframe for receiving the funds from several months at a minimum to a few weeks once the death certificate has been issued.

This leaves the liquid funds accessible to pay the outstanding IHT bill which is due within 6 months of the date of death. This ensures that interest will not begin to accrue, which at the current rates can become significant.

Utilising a trust also provides an individual with greater control over the direction of their assets on death. If they don’t have a life policy trust, other funds and assets may need to be sold to pay any outstanding debts and IHT liability.

Having a life policy trust also allows an individual to decide who to appoint as your beneficiaries and trustees. Setting up a trust is especially important if you’re not married or in a civil partnership, as otherwise, your assets may not transfer to the intended recipient.

Which type of trust should be set up?

Often HNW individuals will already be utilising traditional trusts as part of their wealth planning arrangements, and it is possible to place a life policy into an existing trust.

Alternatively, the policy provider may have standard trust documents that can be used to place the policy into trust. A financial planner will be able to assist with selecting the right trust form for you. However, in some cases we would recommend that an individual creates a new bespoke and more flexible trust deed, which our colleagues in Kreston Reeves Private Client can prepare.

It should also be noted that trusts that hold only life insurance policies which pay out on death, terminal or critical illness do not need to be registered on the trust register.

Both bare and discretionary trusts can be used to hold life insurance policies, with the policy proceeds passing to the nominated beneficiaries on death of the life assured in both cases. It is important to note however, that the tax treatment differs between the two trust types, and consideration needs to be given in how the insurance premiums are funded.

If a bare trust is created to hold the life insurance policy, this is a potentially exempt transfer (PET). A PET is not chargeable to IHT in lifetime on any amount gifted, however if the individual dies within 7 years then the value exceeding the available nil rate band will be charged to IHT, and also utilise the nil rate band in priority to the death estate. This would mean that more of the death estate assets would be chargeable to IHT.

If a discretionary trust is created to hold the life insurance policy, this is a chargeable lifetime transfer (CLT). A CLT is not chargeable up to the available nil rate band, but any excess is taxed at 20% to IHT in lifetime and at 40% if the individual dies within 7 years.

The deemed value of a policy at the time of the transfer varies depending on the policy type. Term policies which last for a specified period are not deemed to have any intrinsic value on transfer, nor at the 10-yearly charge point.

However, whole-of-life policies will be valued based on the sum of the premiums paid to date, both at the time of transfer and at each 10 year anniversary. Therefore it is important to ensure that whole-of-life policies are placed into trust at inception to avoid the potential tax charge that will occur if they are transferred in the future when additional premiums have been paid.

When setting up the trust, consideration should also be taken regarding who will pay the policy premiums.

Premiums paid by the individual creating the trust will be deemed to be a further PET in the case of a bare trust and a further CLT in the case of a discretionary trust. However, it is also possible to utilise assets already held within the trust to pay for the policy premiums, which will avoid triggering any further gifts for IHT.

Life insurance trusts are a complex area and care should be taken to choose the right policy and type of trust to suit your circumstances. If you should have any further queries regarding trusts and life insurance policies please contact our trust team using the form below, or our financial planning services colleagues at Kreston Reeves Financial Planning Services Ltd.