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When you die, a payout from your life insurance policy could form part of your estate. As such, your beneficiaries may lose a significant portion of the settlement to Inheritance Tax (IHT).
However, by placing the policy in a trust, you could potentially protect your life cover from IHT. Also, your beneficiaries could use the ringfenced funds to help them pay a large IHT bill when settling your estate.
Your beneficiaries could pay a significant amount of Inheritance Tax on your life insurance settlement
If your life insurance policy is not in a trust, the settlement is paid to your estate when you die. The executor of your will then adds up the total value of your taxable assets to determine whether any IHT is due.
In 2025/26, you can pass on up to £325,000 without IHT being due. This is your “nil-rate band”. You may also benefit from a “residence nil-rate band” of up to £175,000 when passing your main home to a direct descendant.
You can also pass your entire estate to a spouse or civil partner without IHT, and they inherit your unused nil-rate bands. This means you may be able to pass on up to £1 million as a couple.
However, as the value of your estate is likely to exceed £2 million, your residence nil-rate band could reduce on a tapered basis. Your residence nil-rate band falls by £1 for every £2 that your estate exceeds the £2 million threshold and disappears completely at £2.35 million.
The “10 times” rule states that your life cover should equal approximately 10 times your salary. Consequently, if you earn at least £100,000, you may have a policy worth £1 million or more.
This means that, if the settlement forms part of your estate, you could quite easily exceed the regular nil-rate bands with a life insurance settlement alone. You may lose more of your IHT-free allowances too if the payout pushes you further over the £2 million threshold.
Any wealth that exceeds the nil-rate bands is taxed at 40%. If you had a life insurance policy worth £1 million, and your nil-rate bands had already been used, this could mean that your beneficiaries pay £400,000 in tax on the settlement.
Placing life insurance in a trust means it no longer forms part of your estate
When you take out a life insurance policy, you can place it in a trust. This means you pass ownership of the policy to a third party (your “trustee”), who manages it on behalf of your beneficiaries.
Once placed in a trust, you no longer own the policy. When you die, the settlement is paid directly to your beneficiaries and never forms part of your estate. Consequently, the funds will not be included in any IHT calculations.
Also, your beneficiaries could receive the wealth from your life insurance policy sooner if you place it in trust. This is because, normally, the executor of the will must pay any outstanding IHT before the estate – including a settlement from a life insurance policy that is not in a trust – is distributed among your beneficiaries.
Conversely, when the policy is in a trust, the funds can be released without the need to wait for the rest of the estate to be administered. This means your beneficiaries can use the funds from a life insurance settlement to help them pay a large IHT bill or cover other important costs.
It could be difficult to make changes to your life cover after placing the policy in trust
While there are benefits to placing life insurance in trust, it is important to consider the potential challenges.
Depending on the type of trust you use, you may not be able to make changes to your life cover in the future. This could cause problems if you separate from a partner and they are still named as a beneficiary, for example. You might want to add children or grandchildren as beneficiaries too, and this may not be possible.
The rules surrounding trusts can be complex, so it is imperative that you seek professional advice to help you navigate these challenges and determine which type of trust is most suitable.
Get in touch
Our wealth planners can offer bespoke guidance to help you protect a life insurance settlement from IHT.
Please email info@ipscap.com for more information. If you are already a client with us, speak to your relationship manager to learn more.
Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
All information is correct at the time of writing and is subject to change in the future.
Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
The Financial Conduct Authority does not regulate estate planning, tax planning, or trusts.
Note that life insurance plans typically have no cash in value at any time and cover will cease at the end of the term. If premiums stop, then cover will lapse.
Cover is subject to terms and conditions and may have exclusions. Definitions of illnesses vary from product provider and will be explained within the policy documentation.
