Life Insurance and Inheritance Tax

Many people take out life insurance policies without receiving professional financial advice. As a result, they may not realise that if a life insurance policy is not written into trust, the payout is usually considered part of their estate when they die.

This can create a significant inheritance tax liability, as estates above the available tax-free allowances can be taxed at 40%.

Based on HMRC’s statistics, the average additional inheritance tax bill linked to life insurance policies was around £48,000 per affected estate.

One of the most effective ways to reduce inheritance tax on life insurance is to place the policy into a trust.

When a life insurance policy is held in trust:

• The policy proceeds are generally kept outside the estate for inheritance tax purposes.
• Beneficiaries can often receive the payout more quickly.
• Funds can be accessed without waiting for probate to be completed.
• The payout can be used immediately to help cover inheritance tax liabilities and other estate costs.

In many cases, insurers provide trust forms free of charge, making the process relatively straightforward.

Although setting up a trust can be simple, deciding whether it is the right option for your circumstances requires careful consideration.

Once a life insurance policy has been written into trust, it can be difficult, and sometimes impossible, to reverse the arrangement. Seeking professional financial or legal advice can help ensure the trust structure meets your family’s needs and long-term estate planning goals.

For most people, placing a life insurance policy into trust will not create inheritance tax issues.

However, special rules may apply if the policyholder is seriously ill when the trust is created. If they die within seven years, HMRC may argue that the policy had a measurable value at the time it was transferred into trust. In some circumstances, that value could still be considered part of the estate for inheritance tax purposes.

This is one reason why obtaining specialist advice before making any changes is highly recommended.

As a general rule:

Usually Suitable for Trusts

• Single-life policies
• Joint-life second-death policies
• Policies specifically designed to cover inheritance tax liabilities

Usually Not Suitable for Trusts

Joint-life first-death policies are often intended to provide financial support for the surviving spouse or partner. If these policies are placed into trust, the surviving policyholder may be unable to benefit from the payout when the first death occurs.

Because every situation is different, tailored advice should always be sought before proceeding.

Another major advantage of placing life insurance policies into trust is that payments are typically made directly to beneficiaries rather than through the estate.

This can significantly reduce delays and provide immediate access to funds at a time when families may need them most. It can also ensure inheritance tax bills are settled quickly, helping to avoid additional stress during the probate process.

Inheritance tax continues to affect a growing number of families across the UK.

During the 2023/24 tax year:

• Around 30,400 estates paid inheritance tax.
• HMRC collected approximately £7 billion in inheritance tax revenue.
• Nearly one in four taxable estates included a life insurance policy.

With inheritance tax allowances frozen until 2031, more families are expected to be caught by inheritance tax in the coming years as property values, investments and overall estate wealth continue to rise.

If you already have a life insurance policy, it may be worth reviewing whether it is written into trust as part of your wider estate planning strategy.

A simple review today could potentially save your beneficiaries thousands of pounds in unnecessary inheritance tax and help ensure that more of your wealth passes to the people you care about most.

Writing a life insurance policy into trust can be one of the simplest and most effective ways to reduce inheritance tax, speed up probate, and protect more of your family’s inheritance. However, professional advice should always be sought before making any changes to ensure the arrangement is right for your circumstances. We’re here to help on 01384 376 964.

Folkes Worton LLP Chartered Accountants
Accounting for the Future