Pitfalls of Paying Inheritance Bill with Life Insurance in Trust

Published / Last Updated on 17/08/2022

Many people set up life insurance policies and put them in trust for loved ones to pay their inheritance tax liability on death but there are tax liabilities if you use the wrong trust or premiums are paid from the wrong type of 'income'.

Inheritance tax is not a ‘death tax’ it is a ‘gift tax’.  Therefore, we need to understand some basic gifting rules to make sure the life insurance policy in trust works as you want it to.

£3,000 Annual Gift Allowance

We all have an annual gifting allowance of £3,000 pa and if you did not use last year’s gift allowance you have up to £6,000 in allowance that can be used to ‘gift’ the premiums that you pay, so that both the premiums are immediately outside your estate and the life insurance pay out is already in trust for loved ones so it does not form part of your estate on death.

Unlimited Gifts from Normal Income

Provided your standard of living is not reduced, you can make unlimited gifts from normal income that are immediately inheritance tax free.

Remember, gifts from normal income such as earned income, pension income, dividend income are normal income.  Many people use this income to pay the premiums on life insurance that put in trust to pay any inheritance tax liability.  In short, the premium is now the gift.

Note, insurance investment bonds do not generate ‘income’, if you take a % each year, this is a return of original capital and growth and not income.  You cannot gift ‘income’ from insurance bonds.

Potentially Exempt Transfer (PET)

You can gift larger lump sums of more than £3,000 e.g., £200,000, or even £500,000, provided these are gifted to individuals or bare trusts, these are Potentially Exempt Transfers (PET).

  • If you live for 7 years or more, the PET gift or the transfer is outside your estate after 7 years and not subject to inheritance tax. 
  • If you gift as a PET but you died within 7 years, then the whole value of the gift is included in the inheritance tax calculation as it is a Failed PET, it becomes a chargeable lifetime transfer.

Chargeable Lifetime Transfer (CLT)

  • If you gift money, to a discretionary trust or an interest in possession trust or a business, it is not a PET.  It is a Chargeable Lifetime Transfer (CLT).
  • You can gift as many CLT amounts as you wish but as soon as you cross the inheritance tax threshold of £325,000 then Chargeable Lifetime Transfer Inheritance Tax is payable at 20% even though you are still alive.  Remember, inheritance tax is a ‘gift tax’ and not a ‘death tax’.

Life Insurance Policies in Trust

This is where you need to be careful. 

  • If you set up the trust as a discretionary or interest in possession trust, then these trusts and therefore the premiums that you pay are gifts, but the premiums count as Chargeable Lifetime Transfers and gradually, each year you are using up your inheritance tax nil rate band (£325,000) and when you exceed this, 20% CLT tax is payable even though you are alive.  It also uses up your inheritance tax allowance forever.
  • If the life insurance plan is set up with a bare trust it is a potentially exempt transfer and provided you live for 7 years after each consecutive yearly premium (or it is within your £3,000 annual gifting allowance or a gift from normal income {not insurance bond ‘income} then it is free of inheritance tax.

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