Escape This Inheritance Tax Trap

Write your term life insurance policy in trust and you could escape a huge inheritance tax bill.

Who would you rather leave your money to: your family, or the taxman?

I think I can guess what your answer is.

The trouble is inheritance tax planning can be a very complex area. For example, you could waste thousands needlessly if you don't take some simple precautions to keep your term life insurance policy out of the taxman's reach.

Just to remind you, a term life insurance policy provides cover for a specific period of time only. You might arrange for a term policy to run until you retire, for example or, until your children are financially independent.

Although money paid out from your term policy may not be taxable in itself, your estate could be subject to inheritance tax (IHT) if the value on death exceeds the nil rate band. This tax year the nil rate band is £312,000.

So, if your estate is valued above £312,000, the surplus could be taxed at 40%. This means, an estate worth £400,000 could give rise to an IHT liability of £35,200.

Writing your life policy in trust

But there is a way to escape some -- if not all -- of the IHT charge. What's more it can be done pretty easily by writing your life policy in trust.

It concerns me that so few life policies are written in trust. According to broker, Life Direct, just 5% are, leaving the other 95% vulnerable to a substantial IHT charge. Just imagine 40% of the payout from your life policy going to HM Revenue & Customs, instead of your family.

So let's look at the basics first, and see why trusts make sense:

A trust is a legal arrangement under which property -- such as a term life insurance policy -- is held for the benefit of others (known as beneficiaries). The person setting up the trust is known as the `settlor' who appoints trustees to look after the proceeds of the trust according to the trust document.

You -- as the settlor -- will choose beneficiaries who you want to benefit from the proceeds of your policy, for example you might choose your spouse/civil partner, children or grand children.

Until 21 March 2006, if your life policy was written in trust, no IHT would be payable when you set the trust up. Your monthly premiums would probably also have been exempt from the tax. And the sum assured -- that is, the amount you're covered for -- would have been paid free of any IHT too.

But since then, the rules have changed. Tax may now be payable when it wouldn't have been payable before.

When is tax payable?                                                                                         

This is a little complicated but bear with me.

If a life policy is written in trust now, it is usually done through an Absolute Trust or a Discretionary Trust. A key difference between the two is that a Discretionary Trust allows beneficiaries to be changed, while an Absolute Trust doesn't allow this. So, Discretionary Trusts are more flexible and therefore are more commonly used. That's why I'm going to focus on this type of trust now.

When is inheritance tax payable on a Discretionary Trust? On creation of the trust, if the amount paid into the trust (when added to any other chargeable transfers in the previous seven years) is above the nil rate band.*

Remember the nil rate band (NRB) is currently £312,000, but this may change over time.

Tax could also be payable periodically at each 10 year anniversary if the value of the trust is above the NRB, and again when proceeds leave the trust if the value is over the NRB. 

Immediate tax charge

That said, putting a regular premium term life policy in trust doesn't generally give rise to an immediate tax charge* when it is created. This is because the term life policy has no cash-in value. Policies could, however, be deemed to have a value if the life assured -- the person covered by the policy -- is in very serious ill health.

Periodic charge

At each 10 year anniversary, the maximum tax charge that could be applied is 6% of the value of the trust, above the NRB. Again this is unlikely to occur as term policies have no cash-in value. But the charge could apply if the life assured is in very serious ill health.

Exit charge

Finally, an exit charge could be payable, at a maximum rate of 6% of the value of the assets leaving the trust (after a claim has been made). However, if there was no immediate tax charge when the trust was created or at the last 10 year anniversary, there would be no exit charge either.

What you need to know

If all this seems very complicated, don't despair. In summary, my point is simply this: Although trusts have got a little more complicated recently, they are still an effective way to avoid IHT and you should still use them for significantly reducing tax. Remember -- in most cases -- there will be no IHT to pay.

And even if there is an IHT liability, the charges are still a lot lower than the 40% that would be payable with no trust in place.

Other advantages of using a trust

         A trust allows you to control what happens to your money. You will be able to choose who you want to receive the proceeds of your life insurance policy in the event of your death within the specified term, and in what proportion. This avoids dispute and means your money will be left to the person of your choice.

         By writing the policy in trust, the proceeds will be paid to your beneficiaries more quickly, because the trustees can pass the funds onto them directly. Where life policies aren't written in trust, there may be a delay while legal matters are resolved regarding your estate, such as waiting for probate to be granted. This could take six months or more. (Probate allows executors of the Will to deal with the deceased's estate -- for more details, read What Probate Means.)

         The trust should be easy to set up. Most life insurance companies have a short form to complete and it should be free of charge.

And finally, two things to remember:

1.        If your financial situation is complex, you may need to consult a solicitor for inheritance tax advice. There will be a fee for their services, of course. And it's also a good idea to consult a good independent financial adviser who specialises in IHT planning.

2.       Even if you don't think your estate will ever get anywhere near the IHT threshold (currently £312,000), trusts are still crucial for getting money paid out to your beneficiaries fast.

* Immediate Tax Charge - This is charged at 20% and only applies if the value of all chargeable transfers made in the past seven years exceeds the prevailing nil rate band (currently £312,000). A chargeable transfer is a gift made to someone who is not your spouse or Civil Partner, and that is not covered by any specific tax exemptions. In other words, if the total of all trusts that you have set up, gifts made in the last seven years and seven years worth of premiums for this policy do not exceed £312,000.00 no immediate tax charge should be due.

More: Cut Your Life Insurance Costs by 50%...But Hurry! | Compare life insurance quotes at The Motley Fool Life Insurance Service

The comments above are the opinions of the author only and do not represent advice specific to your circumstances

This article has been approved and issued by Direct Life & Pension Ltd who are authorised and regulated by the Financial Services Authority.

The Motley Fool Insurance Service and The Motley Fool Life Insurance is a trading style of The Motley Fool Limited. The Motley Fool Life Insurance is provided and administered by Direct Life & Pension Services Limited. The Motley Fool Limited is an introducer appointed representative of Direct Life & Pension Services Limited, who are authorised and regulated by the Financial Services Authority. Registered Office: The Bailey, Skipton, North Yorkshire, BD23 1DN.