Save your family thousands in taxes
If you die, your dependants might have to pay inheritance tax on any life insurance payout you have arranged for them. Here's how you can prevent that.
Life insurance ensures a family can afford such things as the mortgage and further education for children when a working parent dies, or childcare when a non-working one does.
However, one decision we need to make before signing on the dotted line is whether to leave the payout to the beneficiaries directly, or whether to go about it in a roundabout way. The latter route is putting the life insurance in a trust, which could reduce the beneficiaries' Inheritance Tax bill by tens of thousands of pounds.
What is a trust?
Cutting through the legal jargon, a trust is just an arrangement, often written down in a formal “deed of trust” that helps you or other beneficiaries to avoid tax, or to give you some control over how and when beneficiaries receive your assets.
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There are advantages and disadvantages of writing your life insurance in trust, so here's a summary.
Save on tax
The main advantage of using a trust for your life insurance is usually the tax benefit. If you have, or expect to have, considerable wealth when you die, setting up your life insurance in a trust will mean that the beneficiaries will normally not have to pay Inheritance Tax on the insurance payout.
Normally a £100,000 life insurance payout could be reduced to £60,000 by Inheritance Tax if your property, cash and other assets are worth £325,000, which is the current Inheritance-Tax threshold for individuals. Even if your other assets are worth between £225,000 and £325,000, your life insurance will still be taxed, albeit not as much.
(As an aside, if you are married, you and your spouse own your own home jointly, and you have left everything to him or her, that property should be free of Inheritance Tax, according to guidance from HM Revenue & Customs.)
However, if you write your life insurance in trust, your spouse, children or grandchildren could get the full £100,000.
Distribute your estate more efficiently and effectively
There are several other potential benefits to using a trust for life insurance.
Since the payout from the trust doesn't form part of your estate, it doesn't have so many legal hoops to go through and your beneficiaries can expect that the payout comes faster than it takes for your other assets to be sorted out by the solicitors.
Jane Baker explains why life insurance should be your number one financial priority
When you die your estate is first used to pay funeral costs, then to pay Revenue and Customs and creditors. Only then will your beneficiaries receive what's left. Therefore, if you owe lots of money, it could be that your life insurance will be used to cover those debts – but not if you have written the life insurance in trust.
You will appoint people who are trustees to the trust. If you have children under 18 who are the beneficiaries, the trustees could look after your children's money until they are adults.
How to do it and at what cost
This is the bit you've been waiting for: how much will this large tax saving cost you? Your life insurer should offer you the option of putting your life insurance into trust for free when you take out the policy. You should receive the paperwork to do so.
You might want to ensure the policy is written into a flexible trust, which means you can change the beneficiaries. It will be difficult to break up the trust completely though once you have arranged it though, so bear that in mind. Also, if you have a joint-life insurance plan, it is not likely to be appropriate to use a trust.
I should point out here that there is another way around the tax issue. It is possible to take out life insurance on someone else's life, rather than your own. Your spouse or partner can insure your life themselves.
One potential downside for you is that if you divorce and then die, your ex might still get the benefit. When insuring the life of another, this doesn't have to be set up in trust and there should be no Inheritance Tax payable.
It is not clear cut who gets what when you die if you don't leave a will. Your spouse doesn't necessarily get all of it, nor, if he or she is dead, do your children. After sorting out your life insurance, make a will your next port of call. Have a read of Don’t get ripped off making a Will.