Although you don’t have to pay income tax on payments from life insurance policies, your dependants could still be hit with a nasty inheritance tax bill, which could be avoided with a bit of forward planning.
How inheritance tax works
If, when you die, the value of your estate is valued above £325,000 (if you’re single or divorced) or £650,000 (if you’re married or widowed), everything you own above this threshold will be liable to inheritance tax at 40%. Your estate includes all your assets such as your home, savings, possessions and any life insurance payment – unless it is written in trust.
So if, for example, your estate is valued at £525,000, your inheritance tax bill will be £80,000, which is 40% of the £200,000 above the £325,000 threshold. However, you don’t have to pay inheritance tax on life insurance policies which have been written in trust.
What is a trust?
A trust is a legal arrangement designed to help you ensure that the proceeds from your life insurance policy are used exactly as you intend. If you don’t have a trust, then the money could be used to pay these off outstanding debts, rather than going to your dependants as you instructed.
Trusts enable you to confirm who should receive the proceeds of the policy and they remove the need for probate – the legal limbo into which a deceased person’s affairs can disappear if they don’t leave a will. If your life insurance is ‘written in trust’, your loved ones can get access to the money more quickly – usually just a few weeks after the death certificate is produced.
If the policy isn’t written in trust, your executors will have to apply for a grant of probate, and the policy may not pay out for several months.
Writing the policy in trust means any payment on death is outside of your estate for inheritance tax purposes. In fact, many people take out a life insurance policy written in trust specifically to cover the cost of their inheritance tax liability.
Bear in mind there is a lot of jargon associated with trusts – they are complex legal entities, after all. When you set up a trust, then you are known as ‘the settlor’. You then choose the ‘trustees’, who are responsible for looking after the policy. It is up to them to make sure your beneficiaries receive the money as and when you want them to.
Once a trust has been set up, it can’t usually be cancelled. Control is given to the trustees, so you can’t change it either.
It’s therefore a good idea to take appropriate legal and tax advice before setting up a trust, so that you can make sure you have the right arrangement in place to suit your needs.
If you visit our life insurance shop, you can get quotations from the UK’s leading insurance providers to see how much you’ll pay for life cover.
Please note: Any rates or deals mentioned in this article were available at the time of writing.