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).
Chargeable Lifetime Transfer (CLT)
Life Insurance Policies in Trust
This is where you need to be careful.