Your life insurance payout could be subject to inheritance tax: Should you put it in a trust?

Many people could avoid harsher inheritance tax on their loved ones by putting their life insurance into a trust, new figures from HMRC reveal.

Nearly one in four inheritances subject to inheritance tax was affected by policies that could have been beyond the reach of the tax authorities, according to data from the 2021/22 tax year.

“Many people buy life insurance without advice, so they are not aware that if they do not put the policy into trust, it is included in their estate and they could end up paying 40 per cent tax,” says Sean McCann, chartered financial planner at NFU Mutual.

New HMRC figures show that life insurance policies that ended up in people’s estates were worth a total of £819m, meaning up to £327m of inheritance tax could have been overpaid unnecessarily, it says.

This affected some 6,800 properties of the 27,800 that had to pay inheritance tax that year.

> Ten ways to legally avoid inheritance tax

“Putting life insurance policies into a trust is relatively straightforward,” McCann says. “If you have life insurance and it’s not in a trust, call your provider and ask for a trust form.

‘As long as you are in good health when you place the asset in trust, there are typically no tax implications, as in most cases the policy has no value.’

But he warns: “If you are seriously ill when you put the policy into trust and you die within seven years, HMRC could argue that the policy had a value when you put it into trust and try to include that value in your estate and charge inheritance tax.”

McCann adds: “Using a trust can also mean a quicker payout in the event of a claim as the family will not need to wait for probate, which can make a big difference to dependents who rely on the money to cover everyday bills.”

About 4 per cent of families pay inheritance tax, but revenues have soared as frozen thresholds and booming property prices are catching more grieving people in the net. See the box on the right.

However, those who do pay the tax may be forced to pay tens or hundreds of thousands of pounds.

Bereaved families handed over £5.99bn to the Treasury in 2021/23, £0.23bn more than the previous year, HMRC figures show.

Taking out life insurance can mean your loved ones receive a payout immediately after your death and free of inheritance tax, but you need to set it up correctly.

To avoid having a life insurance policy payout go into your estate and having the taxman seize 40 percent of any amount above your estate tax threshold, you must place it in a trust.

This allows you to designate one or more beneficiaries of the trust, who will be paid the full amount owed when you die.

You can insure your life for the amount you think your beneficiaries will have to pay in inheritance tax to offset your liability.

However, premiums can be high, especially as you get older, and if you cancel a policy you immediately lose all the benefits of having taken it out in the first place.

Writing life insurance in trust is a useful strategy, if done correctly

“One of the challenges when planning for inheritance tax mitigation is balancing access to the money you will need to ensure you can maintain your standard of living with the desire to save tax,” says Ian Dyall, head of estate planning at wealth manager Evelyn Partners.

He says putting life insurance into a trust designed to provide a lump sum in the event of death is a useful strategy.

This ensures that the sum payable on death is not subject to inheritance tax even if you die a few days later, he explains.

‘You have effectively surrendered the policy, but the loss of access is irrelevant as it would normally have no value before your death anyway.’

Ian Dyall offers the following tips for getting the right life insurance policy and setting it up correctly.

1. If the policy is a term policy, then there are no estate tax implications if you die shortly after placing the policy in trust. he writes.

It is not necessary to live seven years.

2. If the policy is an open whole life policy, then the total premiums paid up to the time it is placed in trust will continue to be subject to inheritance tax for seven years from the inception of the trust.

But it is likely to be significantly less than the amount payable in the event of death, so there is still an immediate benefit.

3. Not all policies are suitable for this strategy. Individual life policies are suitable.

Joint life policies that would only pay out in the event of a second death would also be suitable, but joint life policies designed to pay out in the event of a first death generally would not be.

This is because such policies are designed to provide money to the surviving spouse after the death of the first spouse.

If you put it in a trust, then both spouses are giving up the policy and neither will be able to benefit after the other dies.

4. Policies that provide a pre-death sum upon diagnosis of a serious illness, whether individual or joint life insurance, would also generally not be suitable, as the benefits would be available to the sick person.

However, in some cases there are special trusts that split death benefits from illness benefits and put only the death benefits into trust and retain access to any sums paid upon diagnosis of a critical illness.