Life insurance and ‘trusts’

Understanding life insurance and trusts

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Find out how to set up a trust for your life insurance cover

A life insurance pay out is not normally subject to income or capital gains tax, but it could be liable for inheritance tax at 40%. A trust is a legal arrangement that can help you to sidestep inheritance tax (IHT) on the proceeds of a life insurance policy.

Trusts are relatively straightforward, but there are various types and some of the legal jargon can be off-putting. But if you are thinking of setting up a trust, it can help to familiarise yourself with how they work.

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. 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 or trusted family friend. The trustees must be over 18 and it’s simpler if you pick a UK taxpayer.
  • Beneficiaries: Are the nominated people who will receive a pay out from the trust.

What to consider when setting up a trust

Placing your life insurance policy in trust can be arranged by your insurer or solicitor. Here’s what you’ll need to think about when setting up the paperwork:

  • When selecting trustees, it’s a good idea to choose someone who will outlive the settlor.
  • Trustees can be changed, perhaps if one wants to retire, but all the other trustees have to 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.
  • 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 so there are joint settlors, both settlors must sign the deed.
There are various different 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.

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 has been set up.

Split trusts

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 ring fences 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.

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 revoked at a later date.
  • 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.

Information and advice

Your life insurer will usually be able to help you set up a trust at no extra charge. Many companies also have ‘ready-made’ trusts on their websites. However, tax is a complex subject so it might be worth seeking specialist advice before you decide to write your life policy in trust. 

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