Putting Your Life Insurance in Trust: How Trust Funds Work

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Article contents:

What is a life insurance trust?

Why have a life insurance trust?

How does a trust help my young children?

What is probate?

What about trusts to avoid inheritance tax?

What is a life insurance discretionary trust?

Do you need a will if you have a trust?

Can I set up our joint life insurance in trust?

Advantages and disadvantages of a trust

How do I set up a trust for life insurance?

What is a life insurance trust?

There are many aspects of life insurance that can sound confusing – none more than the idea of writing your life insurance in trust. Thankfully, we are here to help make everything seem a lot simpler!

A life insurance trust can be thought of as having someone you trust to look after your life insurance payout for you, after your death.

Why have a life insurance trust?

There are many reasons for putting money in trust, such as:

• If the end beneficiary is too young – this often happens when you are leaving a significant sum of money to your children before they are 18. It is important that someone with a proper understanding of finances deals with the money for them, either holding it until they come of age, or using it for their benefit as they grow up.
• Avoiding probate – the business of probate (explained below) can be time-consuming and mean the life insurance payout could be allocated to pay outstanding debts rather than be used as it is intended.
• Lowering or avoiding inheritance tax – with larger estates, inheritance tax can devastate a life insurance payout. Trusts are often used to avoid this issue.
• Making the money go where you want it to – if you put life insurance in a trust, then the trustee will be able to assign it as you wanted.

How does setting up a trust for life insurance help my young children?

Before a child reaches an age where they properly understand monetary responsibility, leaving large sums of cash to them can be a significant problem. While a five-year old will have no cause to even consider the money, a young teenager may spend their inheritance on frivolous things– and in most cases, children are easily influenced and could possibly be manipulated.

It is therefore important that any inheritance meant for a child once they have grown to adulthood, is kept safe (and out of reach) until that time, and that any funds that you wanted to dedicate for them as they grow up – for schooling, for example, or experiences as they grow – is properly managed in your absence.

When you set up a trust policy for your life insurance, you enter into a legal agreement with the trustee(s). This could be a trusted family member (your spouse, for example), or even a solicitor if there is no one else suitable. The trust agreement will state how you expect the funds to be used for your children, and the trustee will make sure that those funds are managed appropriately.

As part of a trust fund for children, you will also likely stipulate at what age the money should be passed directly on to them, at which point the trustee’s appointment comes to an end.

When you transfer your life insurance policy to trust, you guarantee security for your children’s future.

What is probate? How does a life insurance trust work to help with it?

When you die, someone left behind will be given the task of sorting out your assets – making sure any outstanding debts are paid and then dividing the remaining estate between your beneficiaries as your will states. If there is no will, then that division will be done under the rules of intestacy.

The term for sorting out assets is called probate. It is a process that can be done by a solicitor or by an individual who has applied for the right to do so, but in both cases can take many weeks or months to properly undertake.

If your life insurance policy is not written into trust, then the sum awarded will be added to your overall estate and be subject to the probate process. Funds may be tied up for months and will be used as necessary to cover any debts.

By having a trust, any inheritance can be immediately assigned to the correct beneficiaries, without any delay or unwanted use of the funds.

What about trusts to avoid inheritance tax?

One of the other common uses of life insurance trusts is to move the value of the life insurance away from the overall estate, to avoid substantial inheritance tax (IHT).

Inheritance tax has its complications, but for ease of understanding, it is best thought of as a 40% tax on any amount above £325,000. It is an amount that must be paid as soon as probate is completed, and as such, can force the sale of a family home or cause other traumatising problems for those left behind.

There are two relevant factors regarding life insurance and inheritance tax – the first is regarding the IHT that is placed on the life insurance payout itself. The second is using life insurance to pay any expected IHT that will occur, due to the value of the rest of the estate.

Setting up a trust to avoid inheritance tax on the life insurance sum

If your life insurance is put into a trust and managed by a trustee, then it does not form part of your estate, and is essentially completely free of inheritance tax– 100% of the money will go as you intend.

Without the trust fund, however, a life insurance payout can add a significant amount to an estate, and often pushes the total value up high enough to be subject to inheritance tax.

For example, if the estate includes property valued at £270,000 and other possessions or monies with a combined worth of £50,000 then the total estate value is £320,000 and falls under the threshold for inheritance tax. Add a life insurance policy of £300,000 however, and suddenly £295,000 (£620,000 minus the £325,000 IHT nil-rate band allowance) is subject to a 40% tax – that’s £118,000 paid to HMRC.

That £118,000 will be saved simply by having the life insurance policy written into trust.

Using life insurance in trust to pay inheritance tax

When the estate is already large enough to be subject to substantial inheritance tax, it is often worth setting up a separate life insurance policy in trust for the express purpose of covering that tax bill. By doing so, you save your family the difficulty of raising the funds before your estate is distributed.

An example would be if the house and other estate comes to a total value of £1,000,000. In this instance, £675,000 would be taxed at 40% and the inheritors would be expected to pay a tax bill of £270,000.

By adding a £300,000 level term life insurance policy that is written in trust to one of the beneficiaries, you will provide your inheritors with that money to cover the tax bill upon your death (plus a little wiggle room). This could allow them to continue living in their home, and not have to face the potential horror of losing everything.

Decreasing term assurance (DTA) to pay a mortgage

If you have a DTA insurance policy set up to cover your mortgage upon your death, then you do not need to place it in trust – it is designed so that the payout become part of the probate process, and it will be used to clear the mortgage before the final value of the estate is calculated.

Remember, however, that if (with the mortgage paid off in full) the estate becomes worth in excess of £325,000 then your family will be subject to an inheritance tax bill. It may be beneficial to have a separate level term policy in place to mitigate this, as described above.

What is a life insurance discretionary trust? How do I make sure the money is used as I intend?

A trust is more than a simple agreement, it is a legal contract between yourself and your trustee. There are life insurance trustee responsibilities, and this means making sure that the agreement is followed, and the money is properly used in the way you have expressed.

One type of trust, however, is called a ‘discretionary trust’. By using a discretionary trust, this gives your Trustees the right to make choices over how the money is spent, rather than following your strict wishes. It is normal to make a discretionary trust when appointing a spouse as a trustee over money intended for your children, for example.

If you have very specific requirements regarding the use of the money upon your death, then it is worth getting full legal advice from a solicitor when writing your trust.

Do you need a will if you have a trust?

A life insurance trust policy only covers the use of the money paid by the life insurance company as a result of your cover – it does not affect any of the rest of your estate or belongings in any way. It is important that you have a will to make sure your assets are shared in the way you want.

Unfortunately, in our experience, grieving people do not always act as you would expect them to, and simple disagreements can build into damaging feuds. Here at Quick Quote Protect, we always recommend that you have a will in place to help your family cope after your death and know your wishes.

Can I set up our joint life insurance in trust?

A joint life insurance policy (between spouses with children, for example) can use trusts to ensure the money is correctly used in all instances, with each other named as a trustee for the money intended to go to the children, and a third trustee named should both parents die.

Thus, if one parent dies, the second parent takes over management of the funds, and if the worst should happen and both parents pass away, the money for the policy is placed in trust for the children.

Should I put my life insurance in trust? What are the life insurance trust advantages and disadvantages?

As described above, there are many advantages for setting up a trust for your life insurance, but there are a few disadvantages too.

Advantages:

• Makes sure the money is used as you intend
• Provides children with funds when they come of age
• Helps to avoid long probate periods
• Helps to avoid inheritance tax
• Helps with paying inheritance tax on larger estates

Disadvantages:

• You cannot change your mind – if you have set up a life insurance policy and placed it into trust, the trustee has some legal rights because technically, they own the payout on the policy. This means that if you take out a life insurance policy with a spouse named as the trustee and you subsequently divorce, your ex-spouse still maintains control of the trust and you cannot reassign the value of your life insurance policy. Should you be unhappy with that, you would have to either cancel the policy, or retire them as trustees (with their agreement).
• Trust instructions cannot be broken – if you have set up a non-discretionary trust, then the agreement will be followed even if subsequent circumstances would normally encourage a change.
• Complicated trusts may need legal advice – while it is easy to set up a basic trust, anything with very specific instructions should be written with a solicitor’s help.

How do I set up a trust for life insurance?

At Quick Quote Protect, we have experts on hand who can provide you with the appropriate life insurance trust form, and advise you on how to write a trust. A basic trust, or one that provides a safety net against inheritance tax, is easily done yourself and only takes a short amount of time.

When you discuss your specific needs with one of our advisors, they may suggest that you contact a solicitor for a more comprehensive trust-writing service. This is typically quite rare, as most trusts are very straight-forward.

It doesn’t cost anything for you to write your life insurance policy into trust, and can be done as part of the initial set-up for your policy.

For more information on anything to do with your life insurance policy or trusts, please give our advisors a call – we are here to help you get the perfect life cover.