Maximizing Life Insurance Benefits: Avoiding Iht

Life insurance is a monetary safety net for loved ones, with individuals paying regular instalments to an insurance company. In return, the insurance company commits to paying out a lump sum to beneficiaries upon the policyholder's death. However, if the total value of the policyholder's estate is more than £325,000, inheritance tax (IHT) will be deducted from the insurance payout at a rate of 40%. This means that the beneficiaries could receive 40% less than expected. To avoid this, the policyholder can write their life insurance policy into a trust, which removes the policy from their estate, ensuring that the beneficiaries receive the full amount without it being subject to IHT.

Write your life insurance policy in trust

Writing your life insurance policy in trust is one of the best ways to protect your family’s future in the event of your death. It is a straightforward legal arrangement that lets you leave assets to friends, relatives, or whoever you pick as beneficiaries. A trust is managed by one or more trustees—family members, friends, or a legal professional—until it pays out to your beneficiaries, either upon your death or on a specified date such as when a child turns 18.

There are several types of trusts to choose from, each with its own advantages and disadvantages. Here are some of the most common types:

Discretionary Trusts

Discretionary trusts give trustees a high level of discretion in deciding which beneficiaries to pay and how much. They use your letter of wishes, which outlines your intentions for how the trust should be administered, as a guide. This type of trust offers flexibility, as you don't need to decide immediately who will benefit or how much they will receive. You can also usually add other trustees to a discretionary trust once it has been established. However, keep in mind that with this type of trust, you hand over many of the decisions to the trustees.

Flexible Trusts

Flexible trusts are similar to discretionary trusts, but they require you to name at least one "default" beneficiary. These beneficiaries are entitled to any income from the trust as it arises. If there is no income generated by the trust, such as when the life policy is the only asset, the default beneficiaries will receive the full pay-out. There can also be “discretionary” beneficiaries who will only receive income or capital if the trustees make appointments during the trust period.

Absolute Trusts

Absolute trusts, also known as "bare" trusts, have fixed beneficiaries that cannot be changed in the future. This includes any children born later or a spouse following a divorce. The advantage of absolute trusts is that pay-outs can be made quickly without long legal delays, and inheritance tax is typically nil or negligible. However, it's important to note that you won't be able to change your beneficiaries with this type of trust.

Survivor's Discretionary Trust

This type of trust is specifically designed for joint life insurance policies and pays out to the surviving policy owner. For example, if you die before your partner, they would inherit your policy before your beneficiaries. If both policy owners die within 30 days of each other, the beneficiaries will receive the pay-out in the same way as a discretionary trust.

When deciding to write your life insurance policy in trust, it is important to carefully consider the different types of trusts available and seek legal and financial advice. While there are benefits to putting your life insurance in trust, there are also some downsides and irreversible decisions to keep in mind.

Understand the tax threshold

Understanding the tax threshold is crucial when it comes to inheritance tax (IHT) and life insurance. In the UK, the IHT threshold, also known as the 'nil-rate band', is set at £325,000. This means that if your estate is worth less than £325,000 when you die, your beneficiaries will not have to pay any inheritance tax. This threshold has been in place since 2009, but its real value has decreased over the years due to rising house prices, resulting in more estates becoming liable for IHT.

It is important to note that spouses and civil partners are exempt from paying IHT. They can combine their thresholds, resulting in a combined 'nil-rate band' of £650,000. Additionally, if you leave your main home to your children or grandchildren, the threshold can increase further. The additional amount that can be passed on tax-free in this case is £175,000, known as the 'residence nil-rate band'. This brings the total tax-free amount to £500,000 per person.

If your estate exceeds the threshold, any amount above it will be taxed at a rate of 40%. This includes the value of your property, savings, investments, personal belongings, and life insurance payout. Therefore, careful planning is essential to minimise the IHT burden on your beneficiaries. One way to do this is by taking out a life insurance policy and writing it into a trust. This removes the policy from your estate, ensuring that your beneficiaries receive the full benefit of the policy without incurring additional taxes.

It is worth noting that tax laws and regulations can change, and it is recommended to seek professional financial advice to ensure your estate planning is optimised to minimise the impact of IHT.

Use a whole-of-life insurance policy

If you're looking to avoid IHT on your life insurance payout, one strategy is to use a whole-of-life insurance policy and write it into a trust. This is a powerful way to mitigate IHT. Here's how it works and what you need to know:

A whole-of-life insurance policy is a type of life insurance that covers you for your entire life, rather than a specified term. This means it will pay out a lump sum upon your death, whenever that may be. Unlike term life insurance, which only pays out if you die within a certain period, whole-of-life insurance provides a guaranteed payout as long as you keep paying the premiums.

Writing a Whole-of-Life Insurance Policy into a Trust:

To avoid IHT, you can write your whole-of-life insurance policy into a trust. This means the policy is owned by trustees, typically solicitors, family members, or friends, who manage it on behalf of your chosen beneficiaries. By doing this, the payout is no longer considered part of your estate, and thus, IHT is not applicable. This ensures your beneficiaries receive the full amount.

Benefits of Writing a Whole-of-Life Insurance Policy into a Trust:

There are several advantages to this approach:

• IHT Mitigation: The payout from the policy can be used by your beneficiaries to settle any IHT bill on the rest of your estate, ensuring your loved ones receive the full intended amount.
• Speedy Payout: Trusts bypass probate, which can be a lengthy process. As a result, your beneficiaries will receive the money much quicker, often within a few weeks.
• Control Over Beneficiaries: You can specify who will receive the payout, ensuring your assets go to the intended beneficiaries, especially if you're not married or in a civil partnership.
• Cover Outstanding Debts: The payout from the policy can also be used by your loved ones to settle any outstanding debts, such as a mortgage, rather than using their inheritance or selling the family home.
• Value for Money: Whole-of-life insurance policies can be decent value, especially when wrapped into a trust, as they provide a guaranteed payout and help reduce the value of your estate, further lowering potential IHT liability.

Setting Up a Trust:

You can set up a trust when you first take out the policy, and it's a relatively straightforward and typically free process. There are two main types of trusts: discretionary trusts, which are for a group of potential beneficiaries, and absolute trusts, which have specific beneficiaries that cannot be changed. It's important to choose the right type as it cannot be altered once established, so consider seeking advice from a financial adviser.

Use a term life insurance policy

Term life insurance is a common and straightforward type of life insurance. It pays out a cash sum if you die within the term of the plan and is not normally subject to income or capital gains tax. You can choose a term between five and 70 years. This means that if you die outside the policy term, there won't be a payout. So, if you want to use the life insurance payout to pay your estate's inheritance tax, you'll need to have another source of funds to cover the tax.

Term insurance is primarily taken out to provide financial security for the policyholder's family. For example, if you have young children, you might take out level term insurance to provide a lump sum of money to your family if you die within a specified period. This type of insurance is known as a 'qualifying policy' in tax terms.

There are several types of term insurance, including:

• Level term insurance: Pays out a fixed sum if you die during the policy term.
• Increasing term insurance: Designed to keep pace with rising prices and inflation, the sum insured maintains its real value throughout the term.
• Decreasing term insurance: Covers a debt that reduces over time, such as a repayment mortgage. Premiums for this type of insurance are lower than for level term insurance or increasing term insurance.
• Convertible term insurance: Allows policyholders to convert their policy into a whole-of-life policy.
• Renewable term insurance: Gives policyholders the option to renew their life cover when the policy term ends without a health review.

When deciding whether to use term life insurance, it's important to consider the level of cover you need and whether the premiums could rise in the future. It's also worth comparing quotes from different insurers to ensure you get the best deal.

Consult a financial advisor

Consulting a financial advisor is a crucial step in understanding how to avoid inheritance tax (IHT) on your life insurance. Here are some detailed instructions and considerations to keep in mind:

Understanding IHT and Life Insurance

Before consulting a financial advisor, it's helpful to understand the basics of IHT and how it relates to your life insurance policy. IHT is a tax levied on the estate of a deceased person, which includes their property, money, and other assets. The current IHT threshold in the UK is £325,000, meaning that if your estate is valued above this amount, your beneficiaries may have to pay a 40% tax on the excess. Life insurance payouts are typically considered part of your estate, so they can be subject to IHT if not properly planned for.

Choosing the Right Financial Advisor

When choosing a financial advisor, look for someone who is a qualified professional, registered in England, and authorised and regulated by the Financial Conduct Authority. This ensures they have the necessary knowledge and expertise to provide accurate and compliant advice. You can use online directories or referral services to find reputable financial advisors in your area.

Discussing Your Options

During your consultation, the financial advisor will assess your individual circumstances, including the value of your estate, the type of life insurance policy you have or are considering, and your beneficiaries. They will then be able to provide tailored advice on how to minimise or eliminate the IHT burden on your beneficiaries. This may include strategies such as writing your life insurance policy into a trust, which removes it from your estate and ensures the payout is tax-free for your beneficiaries.

Understanding the Benefits and Consequences

Putting your life insurance policy into a trust offers several advantages, including legally avoiding IHT, expediting the payout process, and providing control over how the proceeds are disbursed. However, it's important to be aware of the legal and tax consequences of setting up a trust. Once established, a trust usually cannot be changed or cancelled, so it's essential to make an informed decision with the guidance of your financial advisor.

Ongoing Financial Planning

Avoiding IHT on your life insurance is just one aspect of comprehensive financial planning. A financial advisor can provide ongoing advice and guidance to ensure your overall financial strategy is optimised for your goals and needs. This may include reviewing your life insurance coverage, investing in other tax-efficient vehicles, or exploring additional ways to minimise your tax liability.

In conclusion, consulting a financial advisor is a crucial step in understanding and implementing strategies to avoid IHT on your life insurance. They can provide personalised advice, ensure your financial plans are compliant and up-to-date, and give you peace of mind that your beneficiaries will receive the maximum benefit from your life insurance policy.

Frequently asked questions