Relevant Life Insurance and Inheritance Tax – How the Trust Works

When directors arrange a relevant life policy, most of the conversation focuses on the tax efficiency of the premiums: corporation tax relief, no Benefit in Kind, no employer’s National Insurance. These are the features that make relevant life such a compelling planning tool for limited company directors.

But there’s a second layer of tax efficiency built into every relevant life policy that gets far less attention and, for directors with estates that might be subject to inheritance tax, it matters just as much.

A relevant life policy is written into a discretionary trust as part of the arrangement. That trust structure isn’t just a compliance requirement, it’s one of the most valuable features of the policy, keeping the payout outside your estate and away from inheritance tax entirely.

Here’s how it works.

What happens to a life insurance payout without a trust

If you have a personal life insurance policy that isn’t written in trust, the payout on your death forms part of your estate. It’s added to everything else you own – your home, your savings, your investments, your business interests – and inheritance tax is calculated on the total.

At the current standard inheritance tax rate of 40% on everything above the nil rate band threshold, a £500,000 life insurance payout that forms part of your estate could generate a significant IHT liability. The very money that was supposed to provide financial security for your family ends up being taxed before it reaches them.

There’s also a practical problem. Assets that form part of your estate can’t be distributed until probate is granted, a process that can take months, sometimes longer, particularly where an estate is complex. Your family may be waiting for access to funds they urgently need during a period that is already extremely difficult.

How the trust changes both of those problems

When a relevant life policy is written into a discretionary trust, which it must be as part of the HMRC qualifying conditions, the payout doesn’t form part of your estate. It belongs to the trust, which holds it for the benefit of your nominated beneficiaries.

The consequences of this are significant.

Outside your estate:  The payout doesn’t get added to your other assets when the IHT calculation is made. On a £500,000 policy, that’s a potential saving of up to £200,000 in inheritance tax, money that stays with your family rather than going to HMRC.

‍No probate delay:  The trustees can distribute the funds to your beneficiaries as soon as the claim is settled, typically within weeks of the insurer receiving the claim. Your family has access to the money when they need it, not months later.

‍Free of income tax:  A lump sum received from a trust isn’t treated as income for the recipients, so there’s no income tax charge on top of everything else.

How the discretionary trust works in practice

A discretionary trust is a legal arrangement in which the trustees hold assets on behalf of a group of potential beneficiaries, with discretion to decide how those assets are distributed. In the context of a relevant life policy, the trust holds the policy on behalf of your nominated beneficiaries, typically your spouse or partner, children, and potentially other family members.

When you set up the relevant life policy, you complete a nomination of beneficiaries form identifying who the potential beneficiaries are. The trustees, who are typically you, your spouse, and in some cases a professional trustee, then have discretion to distribute the payout among those beneficiaries in whatever way is most appropriate at the time of a claim.

The discretionary nature of the trust is actually an advantage. It means the distribution can be tailored to the family’s circumstances at the time. If your children are very young when a claim is made, the trustees might hold funds on their behalf rather than distributing immediately. If your spouse has remarried, different decisions might be appropriate. The flexibility to respond to actual circumstances rather than being bound by fixed instructions is one of the most practical features of a discretionary trust.

Is there any inheritance tax on the trust itself?

This is a question that sometimes comes up, whether the trust itself is subject to inheritance tax. For most relevant life policy trusts, the answer is no, or at least not in a way that creates a meaningful liability.

Discretionary trusts can be subject to periodic charges and exit charges under the inheritance tax rules but these typically only apply to trusts with significant assets, and in the context of a relevant life policy the trust generally only holds assets when a claim has been paid. Once the payout has been distributed to the beneficiaries, the trust holds nothing and no charge arises.

Your adviser or accountant can confirm the specific position for your arrangement, but for the vast majority of relevant life policies the trust structure is clean from an IHT perspective both for your estate and for the trust itself.

The trust is set up as part of the application

One question directors often ask is how complicated the trust is to set up. The answer is that it’s handled as part of the application process. Your adviser prepares the trust documentation, you sign it, and the policy is written into trust from the outset.

There’s no separate legal process, no additional cost, and no ongoing management required on your part. The trustees’ role is only activated if a claim is made and, until then, the trust sits quietly in the background doing exactly what it’s designed to do.At Executive Life the trust is set up alongside the policy as standard. It’s not an optional extra or an add-on, it’s an essential part of the arrangement that we handle for every client as part of the service. Want to find out more? Arrange a 10-minute call with our team today.