There are two main types of life insurance. Term insurance pays out if you die within a certain timeframe, while whole-of-life insurance pays out when you die, whenever that might be.
Whichever sort of policy is under discussion, it is important that it is ‘written in trust’.
This is the process of placing your policy inside a legal entity called a trust, which is done for two reasons:
- to prevent the proceeds of a pay-out from the policy becoming liable to inheritance tax, and
- to prevent the proceeds falling within your estate and thus becoming part of the process called probate, which is the distribution of your estate following your death
Before we explore the benefits of trusts for life insurance, let’s re-cap why life insurance is so important, and which type is right for you.
The aim of term insurance is to provide a lump sum payment or a regular income to your dependants if you die within a specified period – the ‘term’.
This money can be used for any purpose but is usually intended to clear any outstanding debts (such as a mortgage) and to provide funds for the dependants’ living expenses.
You choose the term of your policy according to factors such as the length of time until your mortgage will be paid off, and how many years it will be until you can expect your children to be financially self-sufficient.
As you’d expect with such an important part of financial planning, there are several points to consider.
While term insurance is designed to pay out if you die unexpectedly, whole-of-life insurance is certain to pay out when you die, no matter how long you live.
Whole-of-life cover is bought as a tax-planning device or as an investment vehicle for those looking to provide a legacy to their heirs. It is not intended to provide dependants with day-to-day financial support or pay off a mortgage or other debt.
If you’re interested in buying whole-of-life insurance, you should consult a professional financial adviser who can guide you through the complexities of the topic.
How do life insurance trusts protect your policy pay-out?
The proceeds of a life insurance policy are not subject to income tax or capital gains tax, but they are potentially liable to inheritance tax (IHT), which is levied at 40%. When you die, your estate is valued. If the total amount is below £325,000, there is no IHT to pay. Likewise, if you leave everything above the £325,000 threshold to your spouse, civil partner, a charity or a community amateur sports club, there is no tax to pay.
While £325,000 is a huge amount, it is within reach of a significant number of people, especially when you consider how much their house might be worth. Add in the proceeds of a life insurance policy and it is apparent why IHT needs to be taken into consideration.
This is where the life insurance trust comes into play.
When you set up a trust, you effectively transfer ownership of the policy to the trust (although you remain responsible for paying the premiums). This mean the proceeds, if there’s a claim, are not included within your estate, so they do not affect the IHT calculation and will be paid in full.
Additionally, since the proceeds fall outside your estate, they are not subject to probate, which means they can be distributed much more speedily than would otherwise be the case.
How do I set up a trust?
When you buy life insurance, the company you’re buying from will be able to put the policy into trust for you, once you’ve provided details of the trustees and beneficiaries.
When you run a quotation with MoneySuperMarket, the results will show whether the insurance company automatically includes the policy being written in trust.
If you already have a life insurance policy that is not written in trust, you can arrange for it to be put into trust. Talk to your financial adviser or the insurer to find out the status of your policy.
You may need a solicitor to help you put an existing policy into trust.
If you have life insurance via your work (usually called ‘death in service’ benefit), any pay-out would be channelled through a trust set up by your employer.
Settlors, trustees and beneficiaries
When setting up your life insurance policy in trust, there are three parties that will be referred to:
- The settlor: The settlor is the person who currently owns the life insurance policy and who wants to set up the trust, transferring legal ownership to the trustees – so that’s you. The settlor remains responsible for paying the premiums on the policy
- Trustees: The settlor is normally also a trustee and must appoint at least one other trustee, perhaps a solicitor, family member or family friend. The trustees must be over 18 and it’s simpler if you pick a UK taxpayer
- Beneficiaries: These are the nominated people who will receive a pay-out from the trust
What to consider when setting up a trust
Here’s what you’ll need to think about when setting up a trust:
- When selecting trustees, it’s a good idea to choose people who are likely to outlive the settlor. If you opt for a solicitor, the trust will be managed by the firm if the individual were to die before you
- Trustees can be changed, perhaps if one wants to retire, but all the other trustees must agree. If a trustee dies, the others can choose a replacement
- If the settlor fails to pay their life insurance premiums, the trust will cease (as will the policy itself)
- The trust deed sets out the terms and conditions of the trust and must be signed by the settlor and the trustees. If it is a joint life policy and there are joint settlors, both settlors must sign the deed
There are various types of trust and it’s important to make the right choice because once you have put your life insurance in trust it cannot normally be taken out again. The decision is said to be ‘irrevocable’.
Discretionary and absolute trusts
Some trusts, known as discretionary trusts, allow you to include a wide range of potential beneficiaries, and also to add beneficiaries after the trust has been set up. The trustees decide who will receive any money and how much, though the settlor can write a ‘letter of wishes’ as guidance.
Absolute trusts are more rigid and do not accommodate any changes. You could not, for example, add any children or grandchildren who were born after the trust had been set up.
Settlors cannot usually be beneficiaries of trusts, which can cause a problem if you have critical illness cover that would pay out a lump sum if you were diagnosed with one of a list of serious illnesses.
A split trust is likely to be more suitable if you have both life and critical illness cover because it splits out the critical illness cover for the benefit of the settlor but ensures the life insurance is held for the beneficiaries.
Pros and cons of trusts
Ultimately, setting up your life insurance in trust ringfences your pay-out and eases the stress your beneficiaries will have to go through when dealing with your policy after you pass away.
As with anything that’s legally binding, it’s always worth thinking about the advantages and disadvantages before you proceed.
- Once you pass away, the pay-out from the policy will not be subject to IHT
- Proceeds from the pay-out should be relatively quick as you won’t need to await probate
- Your pay-out will go to the people you want it to go to
- Once a policy is in trust, the legal agreement can’t be subsequently revoked
- The trustees have legal ownership over the policy and have a certain level of control alongside you – make sure your trustees are people who will protect your interests in years to come