Writing a life insurance, or life assurance, policy in trust can help your family avoid a big tax bill on the payout they receive. Find out how life insurance is taxed, and how to set up your policy to avoid it.

Are life insurance payouts taxed?

Life insurance pays out a cash lump sum to your loved ones if you pass away during the term of your policy.

There are three types of life insurance: term life insurancewhole-of-life insurance and family income benefit insurance, which all pay out in slightly different ways.

This money is not subject to income tax or capital gains tax, so in most cases, your family will receive the money in its entirety.

However, if you fail to set up your policy in a certain way, your family could lose as much as 40% of it to inheritance tax.

We’ve explained how this works in our guide to inheritance tax. Only 5% of the population pay the tax, but if your family gain a large life insurance payout on top of inheriting your other assets in your ‘estate’, there’s a risk they could end up paying tax on some or all of it at 40%.

For example, a £200,000 insurance payout would amount to just £120,000 after tax.

Looking to buy life insurance?

Our partner LifeSearch has over 20 years’ experience of helping consumers find the right life insurance policy.

Arrange a call to discuss your options.

What is writing life insurance policy in trust?

One way to avoid this is to have your life insurance policy written ‘in trust’.

A trust is essentially a legal arrangement, where the trust takes ownership of certain assets. You appoint a trustee or trustees to oversee the trust. These could be family members, friends or perhaps a solicitor.

The job of the trustees is to ensure that the assets contained within the trust go to the named beneficiaries. In other words, the money goes where it is supposed to, rather than into the hands of the taxman.

The named beneficiaries would likely be your partner or your children – the people you want to benefit from the life insurance payout.

How does writing a life insurance policy in trust help?

When assets are placed within a trust, you effectively give up ownership of them. They are now under the management of the trustees, not you, and are no longer classed as being part of your estate.

This is a really important distinction. It means that should you die, the insurance policy will be handled separately to your actual estate, and so won’t be subject to inheritance tax if your estate is valued above the tax threshold.

It means that your family will receive the full payout, without any tax deducted.

What are the different types of trust I could use?

Trusts come in all shapes and sizes – and can range in complexity based on your wishes and what you want to use the trust for.

There are two main forms of trust: a bare trust and a discretionary trust.

In a bare trust, the money is held by a trustee, and all of the proceeds should go to the person or people you nominate, when they turn 18 (or 16 in Scotland).

A discretionary trust gives the trustee greater power to decide how much the beneficiaries get and how frequently they get the money, as well as any other conditions you put on it (such as when they are able to receive the money).

There are more options – such as a gift trust, split trusts and more. What you use will depend on the types of life insurance products you hold and what you want to use the trust for. It’s best to seek professional advice if you have complex needs.

Why is writing life insurance into trust so important?

As we’ve said earlier, very few estates actually pay inheritance tax.

So, for most people, the real benefit of writing life insurance into trust means that your family will not need to go through the probate process – which is where your estate is divided up according to your wishes – in order to receive the insurance money.

Probate can be a lengthy process, so having the policy written in trust cuts out delays and ensures your family receives the money much more quickly.

This can be vital after someone dies. If you rely on two incomes to meet mortgage repayments, for example, a long delay due to probate, lasting for six months or more, could have severe repercussions on your ability to repay your mortgage, and could even lead to repossession of your property.

Writing a life insurance policy into trust enables you to avoid this potential pitfall and ensure your loved ones get the benefits as soon as possible.

How do you write a life insurance policy in trust?

The process of writing a life insurance policy in trust is very simple. Most insurers will offer it as an option when you initially take out the policy, and there should not be any extra charge for doing so.

A life insurance policy can be put into trust at any time – you can do it when the policy is first written, or at a later date, it’s entirely up to you.

Transferring an existing life insurance policy into trust may involve the assistance of a financial adviser or solicitor, and so could incur some costs.

Can I change my life insurance policy after it has been written in trust?

It’s important to think carefully about what you want from your life insurance policy before having it written in trust.

That’s because once it has been written in trust, it is no longer under your control – it has been handed over to the trustee or trustees. This is classed as an ‘irrevocable act’, and cannot be undone.

As a result, you need to make sure that your life insurance policy offers sufficient cover and that you are unlikely to need to change the policy in any way before you write it in trust.

Get life insurance and protection advice

Our partner LifeSearch can help you find the right life insurance, critical illness or income protection policy.