Life Insurance and Inheritance Tax: How Writing Your Policy in Trust Could Save Your Family Thousands

Inheritance tax is charged at 40% on the value of your estate above the nil rate band of £325,000. If you pass your main residence to direct descendants (children or grandchildren), you may also qualify for the residence nil rate band (RNRB) of £175,000, giving a combined threshold of up to £500,000 per person — or £1 million for a married couple or civil partners who transfer any unused allowance to the surviving spouse (gov.uk — Inheritance Tax thresholds).

A reduced rate of 36% applies if you leave at least 10% of the net value of your estate to a qualifying charity. Gifts made during your lifetime are free of IHT provided you survive for seven years after making them; taper relief reduces the tax on gifts made between three and seven years before death (gov.uk — Inheritance Tax gifts).

Critically, the nil rate band has been frozen at £325,000 since the 2009-10 tax year and the government has confirmed it will stay there until 5 April 2030. As property values and savings continue to rise, this freeze — a form of fiscal drag — drags more families into the IHT net every year.

A life insurance policy pays out a lump sum when you die (or, in the case of critical illness cover, when you are diagnosed with a specified condition). There are several types of life insurance, including term cover, whole-of-life policies, and decreasing cover linked to a mortgage.

Without any special arrangement, the proceeds of your policy are paid into your estate. They are added to the total value of your property, savings, investments and other assets. If the combined figure exceeds the nil rate band (plus any RNRB), the excess is taxed at 40%.

Example: Sarah has an estate worth £450,000 and a life insurance policy worth £200,000. On her death the total estate is valued at £650,000. After the £325,000 nil rate band, IHT is charged at 40% on £325,000 — a bill of £130,000. Her family must pay this before they can access the estate, and HMRC now charges 7.75% interest on late IHT payments from January 2026 (gov.uk — IHT interest rates).

There is also a timing problem. Probate can take six months or longer, yet IHT is normally due within six months of death. Families often have to borrow or use instalment arrangements to bridge the gap — adding cost and stress at the worst possible time.

Writing a life insurance policy in trust means you transfer legal ownership of the policy from yourself to a trust. A trust is a legal arrangement in which nominated trustees hold an asset on behalf of chosen beneficiaries. You (the policyholder) are the settlor — the person who creates the trust.

Because the policy is no longer owned by you, it does not form part of your taxable estate when you die. The trustees can pay out the proceeds directly to your beneficiaries — usually within days, rather than waiting months for probate (MoneyHelper — Life insurance and trusts).

Most life insurers offer a trust form as a standard option when you take out a policy. Placing an existing policy into trust is also possible, although if you die within seven years of the transfer it may still be treated as part of your estate under the gift rules.

There are several types of trust commonly used:

• Bare trust (absolute trust): The simplest form. Beneficiaries are named and have an absolute right to the trust assets. Cannot be changed once set up.
• Flexible trust (discretionary trust): Trustees have discretion over who receives the payout and how much each beneficiary gets. Useful when circumstances may change.
• Split trust: Separates the life cover and critical illness elements, so a critical illness payout goes to you during your lifetime while the death benefit goes to your beneficiaries.

The FCA recommends checking that any trust arrangement suits your personal circumstances and that you understand the implications before signing.

The potential savings from writing a life insurance policy in trust become clearer when you compare the IHT liability on estates of different sizes. In the examples below, we assume a single person (no spouse transfer) with the standard nil rate band of £325,000 and a life insurance payout of £200,000.

Estate value £500,000 (excluding life insurance)

• Without trust: total estate £700,000. IHT on £375,000 = £150,000
• With trust: estate stays at £500,000. IHT on £175,000 = £70,000
• Saving: £80,000

Estate value £750,000 (excluding life insurance)

• Without trust: total estate £950,000. IHT on £625,000 = £250,000
• With trust: estate stays at £750,000. IHT on £425,000 = £170,000
• Saving: £80,000

Estate value £1,000,000 (excluding life insurance)

• Without trust: total estate £1,200,000. IHT on £875,000 = £350,000
• With trust: estate stays at £1,000,000. IHT on £675,000 = £270,000
• Saving: £80,000

In each case, the saving equals 40% of the £200,000 policy — £80,000. For larger policies, the saving scales proportionally: a £500,000 whole-of-life policy written in trust would keep £200,000 out of HMRC's hands. These are significant sums that could fund a grandchild's university education or provide a vital financial cushion for a surviving partner.

Setting up a trust for your life insurance is simpler than most people expect. Here is a step-by-step guide:

1. New policies — When you apply for life insurance, your insurer will typically offer a trust option as part of the application. Ticking this box and completing the trust form (usually two to four pages) is all that is required. There is normally no extra charge.

2. Existing policies — Contact your insurer and request a trust deed. You will need to choose the type of trust, name your trustees (at least two are recommended), and list your beneficiaries. Some insurers provide downloadable forms on their websites.

3. Choose your trustees wisely — Trustees are responsible for managing the payout and distributing it according to your wishes. Common choices include your spouse, adult children, or a trusted friend. Professional trustees (such as solicitors) can also be appointed, though they may charge a fee.

4. Review regularly — Life changes such as marriage, divorce, the birth of children, or the death of a named beneficiary may mean your trust needs updating. With a flexible trust, the trustees can adjust distributions; with a bare trust, you may need to set up a new arrangement.

5. Keep records — Store the trust deed with your will and let your trustees know where to find it. A letter of wishes (not legally binding but helpful) can guide trustees on how you would like the funds distributed.

For those over 50 with broader financial planning needs, our guide to savings and investments for over-50s covers how life insurance fits into a wider retirement and estate strategy.

For more on this topic, see our guide to How Much Life Insurance Do You Need? A Step-by-Step Calculator Guide for UK.

While trusts are powerful, they are not without nuances. Here are the key points to watch:

• The seven-year rule: If you place an existing policy into trust, the transfer is treated as a potentially exempt transfer (PET). If you die within seven years, the policy value may still be counted in your estate. New policies placed in trust from the outset avoid this issue entirely.
• Loss of control: Once a policy is in trust, you no longer own it. You cannot cash it in or change the beneficiaries (in a bare trust). Make sure you are comfortable with this before proceeding.
• Joint policies: For couples, a joint life insurance policy written in trust on a "second death" basis can be particularly tax-efficient, as IHT is usually only due on the second death. Consider whether you also need income protection for the surviving partner.
• Pension death benefits: Pensions are generally outside your estate for IHT purposes and do not need to be written in trust. See our pensions hub for more detail on how pension benefits are taxed on death.
• Mortgage life insurance: Decreasing term cover linked to a mortgage can also be placed in trust. The payout clears the mortgage directly, keeping the proceeds out of your estate.
• Professional advice: The MoneyHelper service (backed by the government) offers free guidance on estate planning, and a qualified financial adviser can help you choose the right trust structure.

It is also worth noting that the IHT landscape may change. The current freeze on thresholds runs until April 2030, but future governments could raise or lower the nil rate band. Keeping your estate planning under regular review — ideally every two to three years — is prudent.

Writing your life insurance in trust is one piece of a broader estate planning puzzle. To minimise IHT further, consider the following strategies:

Use your gift allowances: You can give away £3,000 per tax year free of IHT (the annual exemption), plus unlimited small gifts of up to £250 per person. Wedding gifts of up to £5,000 (from a parent) are also exempt (gov.uk — IHT exemptions).

Make gifts from surplus income: Regular gifts made from income (not capital) that do not affect your standard of living are exempt from IHT with no seven-year wait, under the "normal expenditure out of income" rule.

Maximise pension contributions: Pensions sit outside your estate for IHT purposes, making them one of the most tax-efficient savings vehicles available. Contributions also benefit from income tax relief.

Consider ISAs carefully: While ISAs are excellent for income tax and capital gains tax efficiency, they do form part of your estate for IHT. Spousal ISAs (APS — Additional Permitted Subscriptions) allow a surviving spouse to inherit the ISA tax wrapper, but the value is still included in the estate. Our savings hub and investing hub cover ISA strategies in more detail.

Write a will: Surprisingly, around 54% of UK adults do not have a will. Dying intestate can lead to assets being distributed in ways you did not intend — and may increase the IHT bill if allowances such as the RNRB are not properly claimed.

This article is for informational purposes only and does not constitute financial advice. You should seek independent financial advice before making any investment decisions.