One small thing that can make the biggest difference to your family when you die

Most people who take out a life insurance policy do so for peace of mind, knowing their family will get a lump sum payout when they pass away.

However, it could also provide a headache for grieving relatives, who can get caught out by unexpected tax bills and payout delays when they try to cash the policy in.

Writing a policy into trust is one way to avoid this. 

It means there’s no need to wait until probate is done for the policy to pay out. In most cases, a trustee just needs the death certificate.

This is especially important given that one in five probate applications are taking six months or more to be processed, according to Family Courts data. In cases where estates are more complicated, probate can take years.

It also makes sure the payout is not counted as part of your estate when you die – the assets in the trust become the property of the trustees, and no longer “yours” – meaning inheritance tax cannot be charged.

As long as a trust is set up seven years before the policy owner’s death, the entire life insurance payout will be exempt from inheritance tax.

James Daley, managing director of Fairer Finance, said this can make a big difference for people with big estates.

But he did warn: “Once they are set up, [trusts] are hard to change – and there have even been cases of people invalidating their insurance by trying to do so.”

What is a trust?

In simple terms, a trust is a legal agreement which allows someone to ring fence some of their assets and control who they are passed onto.

A trustee can be anyone – from a family member, to a friend, or a solicitor. They must be over the age of 18.

You may want to add yourself as a trustee, given that once the trust is set up, the assets will belong to the trustees even while you’re still alive. Even placing yourself as a trustee means the other trustees will need to give sign-off for you to make any further changes.

You can either place a life insurance policy into trust at the point you first set it up, or later down the line.

There are two different types of trusts: a bare trust, and a discretionary trust.

A bare trust is more straightforward. Assets are put in trust, and when the owner of these assets dies, the money is shared out according to the owner’s wishes.

In England and Wales, this kicks in when the beneficiaries turn 18. In Scotland, it’s 16.

A discretionary trust is a bit more complicated, but can be more flexible. In essence, this kind of trust gives trustees more power, as they can decide not only how much each beneficiary gets, but also over what period.

There are also flexible trusts, which are similar to discretionary trusts except you must name at least one default beneficiary, who will receive the full payout unless the trustees choose to give funds to additional “discretionary” beneficiaries.

Split trusts allow you to benefit from critical illness payments while you’re alive, but still leave a life insurance payout for when you pass away.

Finally, a survivor’s discretionary trust is an option for non-married couples where, if one of the partners dies, the survivor can inherit the payout before any other named beneficiaries.

Who can be a life insurance beneficiary?

You can split your payout between as many beneficiaries as you like, but it’s worth noting that the named beneficiaries cannot be changed once a bare trust has been set up – unless you rewrite the entire trust, which could disrupt your policy benefits if not done right.

Adam Higgs, head of product at research firm Protection Guru, said this is probably the biggest downside of putting a policy in trust.

He explained: “This is a risk if you fall out with who you name as your beneficiaries. It’s very difficult because life insurance is a long-term product. You, or an adviser, need to monitor it.

“This isn’t an issue for discretionary trust, only for trusts where you have to name the beneficiary.

“It’s important to monitor your trust generally, so that any major changes in your life are reflected in the way it’s set up.”

Mr Higgs said a lack of awareness and unwillingness to fill out extra paperwork – which multiple parties often have to sign – has put many life insurance policy holders off trusts.

There are still some tax implications

While a key benefit of putting a life insurance policy into a trust is to mitigate inheritance tax, there are other tax considerations worth weighing up.

Firstly, inheritance tax could be charged if you change any named beneficiaries less than seven years before you die.

Alan Richardson, head of advice at insurer LifeSearch, said leaving money in a trust account can create unexpected tax obligations for the trustees. Once the policy has paid out, trustees must keep clear and accurate records and accounts of trust property.

He added: “Trying to place your policy into a trust if there is an ongoing claim for terminal illness can create tax considerations, too.

“Even so, this generally won’t outweigh the inheritance tax liabilities should the policy not be in trust.”

While most insurers provide simple trust set-ups, Mr Richardson said consumers should be aware there are online solutions “susceptible to misunderstanding or even abuse” – particularly if the policyholder is vulnerable. With this in mind, make sure you fully understand what you’re signing up for.

Are there other options?

Beneficiary nomination is one alternative to writing a policy in trust. “It’s great, because it takes a lot of the administration away,” said Mr Higgs.

Royal London says it offers the service to those whose situations are “more straightforward” and where it’s clear they know who they want to benefit from their estate.

On its website, the life insurer says: “We’ll automatically pay any benefit after your client dies to their nominated beneficiary. And there’s no need for probate or the completion of a trust form.”

Once someone has nominated a beneficiary, they can also change it to someone else – a big difference from a bare trust. 

However, you can’t remove all beneficiaries. This is because, to be effective, it must not be possible for the plan to come back into the person’s estate for them to benefit from it; someone else must receive the payout.

There is a catch, though. Some providers still require terminal illness claims to be paid to the plan owner, which would form part of the taxable estate on death.

In other words, a payout of this kind under this set up would be vulnerable to inheritance tax.

What about unmarried couples?

For those couples who are not married, especially those without wills, writing a life policy into trust and then listing the other as the beneficiary can avoid a situation where one is not entitled to inherit anything from the other’s estate.

Paula Llewellyn, one of the managing directors at Legal & General, said setting up a trust is especially important if two people are a cohabiting couple with children.

She explained: “In the eyes of the law, a couple that shares a home – no matter how long for – does not have the same rights as a married couple.

“Even if the intention for the life insurance policy is so that the remaining partner can still afford the property, the children are legally due the payout.

“This is why it’s important to safeguard your estate, so that your family is protected if the worst happens, especially if there is no will in place. 

“Complacency or lack of awareness can be expensive, and there’s no guarantee your estate will go to your loved ones. Putting your life insurance policy into a trust reduces this risk.”