How to protect your life insurance payout from inheritance tax

If you're taking out life insurance, make sure you don't skip this simple step that could save your beneficiaries from a 40% tax bill.

If you've already got a policy, read on to find out if you need to take action to protect your payout from Inheritance Tax (IHT).

Life insurance and Inheritance Tax: how it works

When you take out a life insurance policy, you decide how much you want your beneficiaries to receive. However, if you die and the policy pays out, your loved ones could find that some of the payout is used to pay your IHT bill – which is not what you intended it for.

This is because life insurance payouts can be counted as part of your estate for IHT purposes.

Your estate is the sum total of all the money and assets you own when you die. If it's worth more than £325,000 (or £650,000 for married couples or civil partners) anything above that threshold will be taxed at 40%.

Even if you don't think your estate will be worth £325,000, it is possible that the value of the life insurance payout could push you over the threshold, meaning that some of the payout would be subject to tax.

Fortunately, there's a simple solution to this problem, and it's available to everyone who takes out a life insurance policy – at no extra cost.

Writing your life insurance policy into trust

When you take out a life insurance policy, at some point in the process you will be asked whether you want to write your policy into trust.

Most people don't understand what this means, and simply ignore it – only 6% of people choose to put their policy into a trust.

What many people don't realise is that putting your policy in trust protects the payout from Inheritance Tax. This is because once money or assets are inside a trust, they are no longer counted as part of your estate.

Benefits of putting your policy in trust

As well as protecting your life insurance payout from the impact of Inheritance Tax, placing it in a trust has other benefits:

  • Your beneficiaries will receive the money quickly. Money left in a trust bypasses the probate process, which can take months (and takes even longer if IHT is payable).
  • You can control how and when the money is paid out. A trust allows you to specify how you want the money to be paid; for example, you can ask that the payout be held in trust for a child until they reach a particular age.

How to have your life insurance policy written in trust

The process of putting your policy into trust is simple. When you take out a policy, the insurer will ask you whether you want to write it into trust (often it's an option on a form you'll fill out). Once you've said yes, you'll usually have to fill out another form in which you give details of when, how and to whom you want the policy to pay out if you die.

You may be asked to choose what type of trust you wish to set up. In this case a "discretionary trust" is usually the best option, as it allows you to change the beneficiaries at a later date if you need to.

It may be helpful to understand some of the language around trusts. As the person setting up the trust, you are the "settlor". Assets held within a trust are looked after by the "trustees", who in this case would be the insurance company, and the person who will receive the money when the trust pays out is the "beneficiary".

Tip: If you want to change to a different policy later on (for example if your insurer offers you a better deal) you'll need to ask the insurer to put it into trust again. The trust which contained your previous policy will be dissolved, so you'll need to ask them to set up a new one.

What if you already have life insurance that's not in trust?

If you already have a life insurance policy, you should be able to contact your insurer and ask them to put it into trust for you without too much hassle.

Is your current cover sufficient? It's important to review your policy if your circumstances change. Our life insurance comparison tool lets you compare personalised quotes from insurers across the market, to help you get the best deal for the cover you need.

There's no reason not to put your life insurance policy into trust, so when you come across the question in your policy paperwork, make the choice to protect your loved ones from the impact of Inheritance Tax.

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Last updated: 15 October 2015