Benefits and Disadvantages of Putting Life Insurance in Trust

There are two main types of life insurance. Term insurance pays out if you die within a certain timeframe. Instead, 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 ‘trust’, which is done for two reasons:

• To prevent the proceeds of a pay-out from the policy from becoming liable to inheritance tax.

• To prevent the proceeds from falling within your estate, therefore becoming part of the process called ‘probate’. This is the distribution of your estate following your death.

Before we explore the benefits and disadvantages of putting life insurance in trust, let’s re-cap why life insurance is so important and which type might be best suited to your needs.

Term insurance

The aim of term insurance is to provide a lump-sum payment or a regular income to your dependents if you die within a specified period (i.e., the ‘term’).

This money can be used for any purpose but is usually intended to clear any outstanding debts, such as a mortgage. It can also be used to provide funds for the dependents’ 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. You may also want to take into consideration 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.

Whole-of-life insurance

Term insurance is designed to pay out if you die unexpectedly. Instead, 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 dependents 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. However, 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. This is especially true 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. However, you still remain responsible for the payment of the premiums. This means the proceeds, if there is a claim, are not included within your estate. Therefore, 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. This means they can be distributed much more speedily than would otherwise be the case.

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.

Term insurance

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.

Whole-of-life insurance

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 I set up a trust?

When you buy life insurance, once you’ve provided details of the trustees and beneficiaries, the company you’re buying from will be able to put the policy into trust for you.

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, which is 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. In short, 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, such as 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. 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. They also offer you the chance 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.

Split trusts

Settlors cannot usually be beneficiaries of trusts. This 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. This is because it splits out the critical illness cover for the benefit of the settlor while ensuring the life insurance is held for the beneficiaries.

Benefits and disadvantages of putting life insurance in trust

Ultimately, setting up your life insurance in trust ringfences your pay-out. It also 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 of putting life insurance in trust before you proceed.

Pros

• 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.

Cons

• 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. So make sure your trustees are people who will protect your interests in years to come.

How long will a trust last?

The truth is that it depends. Technically, it can last up to 125 years. In the case of a charitable trust, instead, it can even carry on indefinitely.

But usually, a trust can last as long as you need it, depending on your personal needs and circumstances. For instance, you may only want it to last until your child grows up.

Can I change my mind about putting life insurance in trust?

Generally, you should be able to put life insurance in trust whenever you wish. This needn’t necessarily be when you take out the policy. But when it comes to changing your mind and withdrawing your policy out of the trust, it may not be as straightforward.

In fact, it’s often something that cannot be reversed very easily. This is because, once your policy is in trust, it is under the control of your trustees.

How does life insurance in trust work for cohabiting partners?

When it comes to life insurance, cohabiting couples don’t always have the same rights as married couples. In fact, unless it’s written in trust, the surviving partner of a cohabiting or unmarried couple won’t have an immediate legal claim to a life insurance policy.

So, if you are unmarried but want to ensure your cohabiting partner is financially covered if you die, writing your insurance in trust could be a good option. This way, you can name them as the beneficiary and the proceeds will go to them, rather than to your legal estate.

Compare life insurance with MoneySuperMarket

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