Learning Outcomes
After reading this article, you will be able to explain how life insurance policies can pass property outside the deceased’s estate, identify the legal requirements for excluding policy proceeds from the estate, and apply the relevant inheritance tax rules. You will also be able to distinguish between different trust arrangements for life policies and recognise common exam pitfalls on this topic.
SQE1 Syllabus
For SQE1, you are required to understand the rules and practical implications of property passing outside the estate, with particular focus on life insurance policies. In your revision, pay close attention to:
- the legal effect of writing a life insurance policy into trust
- the inheritance tax treatment of life policy proceeds paid to trusts or nominated beneficiaries
- the requirements for effective exclusion of policy proceeds from the estate
- the impact of trusts (bare, discretionary, interest in possession) on policy proceeds and tax
- common pitfalls, including gifts with reservation of benefit and the three/seven year rules
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What is the effect of writing a life insurance policy into trust for a named beneficiary during the policyholder’s lifetime?
- How are life insurance policy proceeds treated for inheritance tax if the policy is not written into trust?
- What is a gift with reservation of benefit in the context of life insurance policies?
- Which type of trust arrangement for a life policy gives the trustees discretion over who receives the proceeds?
- True or false? If a policyholder assigns a life policy to a trust but continues to benefit from it, the proceeds are always excluded from their estate for inheritance tax.
Introduction
When a person dies, not all property they owned or controlled forms part of their estate for succession or inheritance tax purposes. Life insurance policies are a key example of property that can, if structured correctly, pass outside the estate. This article explains the legal and tax treatment of life insurance policy proceeds, the use of trusts, and the requirements for ensuring that such proceeds do not fall into the estate—an area frequently tested in SQE1.
Life insurance policies and the estate
A life insurance policy is a contract that pays out a lump sum on the death of the insured. By default, if the policy is owned by the deceased and no special arrangements are made, the proceeds are paid to the estate and distributed under the will or intestacy rules. However, with appropriate planning, the proceeds can be paid directly to beneficiaries or trustees, bypassing the estate.
Key Term: estate The property to which the deceased was beneficially entitled at death and which passes under the will or intestacy rules.
Writing a life insurance policy into trust
The most common method of ensuring that policy proceeds pass outside the estate is to write the policy into trust during the policyholder’s lifetime. This is usually done by completing a trust deed provided by the insurer, naming trustees and beneficiaries.
Key Term: writing a policy into trust The act of assigning ownership of a life insurance policy to trustees, so that the proceeds are paid to them for the benefit of named beneficiaries, not to the deceased’s estate.
When a policy is held in trust, the proceeds are paid directly to the trustees on death, who then distribute them according to the trust terms. The proceeds do not form part of the deceased’s estate and are not subject to the will or intestacy rules.
Types of trust for life insurance policies
There are several types of trust that can be used for life insurance policies:
- Bare trust: The beneficiary is absolutely entitled to the proceeds. The trustees have no discretion.
- Discretionary trust: The trustees have discretion over which beneficiaries receive the proceeds and in what shares.
- Interest in possession trust: A beneficiary has a right to income (rare for life policies, but possible).
Key Term: bare trust A trust where the beneficiary is absolutely entitled to the trust property and the trustees have no discretion.
Key Term: discretionary trust A trust where the trustees have discretion over which beneficiaries receive the trust property and in what proportions.
Key Term: interest in possession trust A trust where a beneficiary has a present right to receive income from the trust property.
Inheritance tax treatment of life policy proceeds
If a life policy is written into trust and the policyholder has not retained any benefit, the proceeds are not part of the estate for inheritance tax (IHT) purposes. They are paid directly to the trustees or beneficiaries and are not taxed as part of the deceased’s estate.
If the policy is not written into trust, the proceeds are paid to the estate and are subject to IHT in the usual way.
Key Term: inheritance tax (IHT) A tax charged on the value of a person’s estate at death, subject to exemptions and reliefs.
Gifts with reservation of benefit
If the policyholder writes the policy into trust but continues to benefit from it (for example, by retaining the right to change beneficiaries or access the cash value), the proceeds may still be treated as part of the estate for IHT. This is known as a gift with reservation of benefit.
Key Term: gift with reservation of benefit A gift where the donor retains some benefit from the property given, so that it is still treated as part of their estate for IHT.
The three/seven year rules
When a policy is assigned into trust, this is a lifetime transfer for IHT purposes. If the policyholder survives for seven years after the transfer, the gift is fully outside the estate. If death occurs within seven years, the value of the policy at the date of assignment may be chargeable, subject to taper relief after three years.
Key Term: potentially exempt transfer (PET) A lifetime gift to an individual or certain trusts that is exempt from IHT if the donor survives seven years, but becomes chargeable if they die within that period.
Nominated policies and pension death benefits
Some policies (such as group life cover or death-in-service benefits) allow the policyholder to nominate a beneficiary. If the nomination is effective, the proceeds are paid directly to the nominee and do not fall into the estate.
Key Term: nomination A direction by the policyholder to the insurer to pay the policy proceeds to a named person, bypassing the estate.
Tax and practical advantages
Writing a policy into trust or nominating a beneficiary has several advantages:
- The proceeds are paid quickly to beneficiaries, without waiting for probate.
- The proceeds are not subject to IHT if the trust is effective and there is no reservation of benefit.
- The funds are protected from claims by estate creditors.
Worked Example 1.1
Aisha takes out a life insurance policy and writes it into a discretionary trust for her children. She dies five years later. Are the policy proceeds included in her estate for inheritance tax?
Answer: The proceeds are not included in Aisha’s estate for IHT, as the policy was written into trust and she did not retain any benefit. The trustees receive the proceeds and distribute them to the children according to the trust terms.
Worked Example 1.2
Ben assigns his life policy into a bare trust for his spouse but retains the right to change the beneficiary. He dies three years later. Are the proceeds outside his estate for IHT?
Answer: No. Because Ben retained the right to change the beneficiary, this is a gift with reservation of benefit. The proceeds are treated as part of his estate for IHT.
Worked Example 1.3
Clara nominates her partner as beneficiary of her employer’s group life policy. She dies. How are the proceeds treated?
Answer: The proceeds are paid directly to the nominated partner and do not form part of Clara’s estate for IHT or succession purposes.
Exam Warning
If a policyholder writes a policy into trust but continues to benefit from it (e.g., by accessing the cash value or retaining control), the proceeds may still be taxed as part of the estate. Always check for gifts with reservation of benefit.
Revision Tip
For SQE1, focus on the requirements for effective exclusion of policy proceeds from the estate: (1) valid trust or nomination, (2) no reservation of benefit, (3) survival for seven years after assignment.
Key Point Checklist
This article has covered the following key knowledge points:
- Life insurance policy proceeds can pass outside the estate if written into trust or validly nominated.
- The type of trust (bare, discretionary, interest in possession) affects control and tax treatment.
- If the policyholder retains a benefit, the proceeds may be taxed as part of the estate (gift with reservation of benefit).
- Assignment of a policy into trust is a potentially exempt transfer; survival for seven years is required for full IHT exemption.
- Nominated policies and group life schemes can also pass outside the estate if the nomination is effective.
- Policy proceeds paid outside the estate are not subject to probate delays or estate creditors’ claims.
Key Terms and Concepts
- estate
- writing a policy into trust
- bare trust
- discretionary trust
- interest in possession trust
- inheritance tax (IHT)
- gift with reservation of benefit
- potentially exempt transfer (PET)
- nomination
