Property passing outside the estate - Life insurance policie...

Learning Outcomes

This article outlines how life insurance policy proceeds can pass outside the estate and their legal and IHT treatment, including:

• When policy proceeds form part of the estate and when they bypass it
• Writing a policy into trust versus passing under a will or intestacy
• Bare, discretionary, and interest in possession trusts for life policies, including control and tax implications
• Inheritance tax rules for policy proceeds paid to or via trusts, including the effect of gifts with reservation of benefit
• PET versus CLT classification on assignment into trust and liability for lifetime and death IHT
• Valuation of an existing policy on assignment (IHTA 1984 s.167) and IHT treatment of continued premium payments
• Policyholder powers causing inclusion in the IHT estate under general power principles (e.g., power to change beneficiaries)
• Three/seven year rules and taper relief for policies assigned into trust, distinguishing PETs from CLTs
• Relevant property regime charges for discretionary policy trusts and practical reasons they are usually minimal
• MWPA s.11 trusts, pension scheme death benefits and nominations, and statutory nominations for friendly society/NS&I-type property
• Differences between succession and IHT treatment where proceeds pass outside the succession estate but may still be taxable for IHT
• Common pitfalls, including ineffective trusts, retained benefits, and misconceptions about survival periods

SQE1 Syllabus

For SQE1, you are required to understand how life insurance policy proceeds can pass outside the estate and their legal and IHT treatment, with a focus on the following syllabus points:

• the legal effect of writing a life insurance policy into trust (including MWPA s.11 trusts and express trust/assignment)
• the inheritance tax treatment of life policy proceeds paid to trustees or nominees, and the position where the policy is not written into trust
• PET versus CLT classification on assignment into trust and who is liable for lifetime and death charges
• valuation rules and ongoing premium payments (IHTA 1984 s.167; normal expenditure out of income exemption)
• gifts with reservation of benefit and “general power” analysis (e.g. power to change beneficiaries)
• the impact of trust type (bare, discretionary, interest in possession) on IHT, including relevant property regime charges
• the three/seven year rules and taper relief in relation to policy assignments
• pension scheme death benefits and nominations; statutory nominations for friendly societies and National Savings
• practical advantages of bypassing the estate and common pitfalls (e.g. probate delays, creditor access, ineffective nominations)

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.

1. What is the effect of writing a life insurance policy into trust for a named beneficiary during the policyholder’s lifetime?
2. How are life insurance policy proceeds treated for inheritance tax if the policy is not written into trust?
3. What is a gift with reservation of benefit in the context of life insurance policies?
4. Which type of trust arrangement for a life policy gives the trustees discretion over who receives the proceeds?
5. 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.

A significant distinction runs through this topic. For succession, the “estate” covers assets passing under a will or intestacy. For IHT, property can be treated as part of the deceased’s taxable estate even if it is not payable to the personal representatives (e.g. where there is a gift with reservation of benefit). Keep this dual analysis in mind.

Key Term: estate
The property to which the deceased was beneficially entitled at death and which passes under the will or intestacy rules.

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.

Where a policy is paid into the estate, it is part of the IHT estate unless an exemption applies (e.g. spouse or charity exemption). Even if IHT would ultimately be nil due to exemption, paying into the estate typically causes delay, because the insurer will generally require the grant before releasing funds.

Key Term: assignment
The transfer of rights under a policy from the policyholder to another person or to trustees, typically by deed or insurer’s form.

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. The trust can be created when the policy is taken out or later by assigning the policy to trustees.

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, provided the policyholder has not retained a benefit or a power that brings the policy back into their IHT estate.

Two routes are commonly used:

• an express lifetime trust or assignment of the policy to trustees
• a statutory trust under the Married Women’s Property Act 1882, s.11 (for spouse/civil partner and/or children)

Key Term: Married Women’s Property Act trust (MWPA trust)
A statutory trust under s.11 MWPA where a policy effected on a person’s own life is expressed to be for the benefit of their spouse/civil partner and/or children; proceeds are paid to trustees for those beneficiaries and do not pass via the estate.

A policy can be written into trust from inception (preferred, as it avoids an immediate transfer of value of any surrender value) or by later assignment to trustees. Trustees often hold subject to a letter of wishes indicating intended recipients and shares, especially where the trust is discretionary. Care must be taken not to retain a right to revoke, vary beneficiaries, or otherwise benefit, which could cause inclusion in the IHT estate.

Key Term: relevant property trust
A trust (such as a discretionary trust) whose property is not comprised in the estate of any one individual and which is subject to the IHT “relevant property” regime with potential ten-year and exit charges.

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. For IHT, the gift on assignment to a bare trust is to an individual and is a PET. No relevant property charges arise.
• Discretionary trust: The trustees have discretion over which beneficiaries receive the proceeds and in what shares. For IHT, the trust is within the relevant property regime. The assignment into trust is a CLT; there may be periodic and exit charges later, though these are usually negligible in practice if the fund is distributed soon after death.
• Interest in possession trust: A beneficiary has a right to income (rare for life policies, but possible). Post-2006, many lifetime IIPs fall within the relevant property regime unless exceptions apply.

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 or power that causes inclusion, the proceeds are not part of the estate for 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 (subject to exemptions, reliefs, and thresholds). Paying to a spouse or civil partner via the estate will generally be exempt, but delays will still arise pending the grant.

Key Term: inheritance tax (IHT)
A tax charged on the value of a person’s estate at death, subject to exemptions and reliefs.

When an existing policy is assigned into trust, there is a lifetime transfer for IHT. If the trust is a bare trust (effectively a gift to an individual), the transfer is a PET. If the trust is discretionary, the assignment is a CLT and, in principle, can attract an immediate lifetime charge if the value transferred exceeds the available nil rate band.

Key Term: chargeable lifetime transfer (CLT)
A lifetime transfer that is immediately chargeable to IHT (e.g. a transfer into most discretionary trusts), typically at 20% on the amount above the available nil rate band.

In valuing the policy on assignment, IHTA 1984 s.167 applies. The value is the greater of the market value and the cost of providing the policy, commonly approximated by the total premiums paid to date (for a policy with minimal market value). Early in a policy’s life this value is usually small and covered by exemptions.

Continuing premiums paid after the policy is in trust are transfers of value, but will often qualify for the normal expenditure out of income exemption if they are part of the policyholder’s habitual expenditure, made out of income, and leave sufficient income to maintain the usual standard of living. If not exempt, they may be covered by the annual £3,000 exemption.

Key Term: normal expenditure out of income
An IHT exemption where a transfer is (i) part of normal/habitual expenditure, (ii) made out of income, and (iii) leaves the transferor with sufficient income to maintain their usual standard of living.

Discretionary policy trusts fall within the relevant property regime. In practice, because the policy’s value on entry is low and trustees usually distribute proceeds shortly after death, any ten-year or exit charges are often nil or negligible. A hypothetical rate is computed at the last ten-year anniversary (or at entry if before the first anniversary) and then apportioned; where the hypothetical rate was 0%, exit charges are 0%.

Key Term: relevant property trust
A trust subject to the IHT periodic (ten-year) and exit charge regime, typically including discretionary trusts.

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. Apart from GWR rules, the value may be included by reason of the deceased retaining a “general power” over the disposition of the policy benefits.

Key Term: gift with reservation of benefit
A gift where the donor retains some benefit in, or control over, the property given so that it is treated as part of their estate for IHT.

Key Term: general power
A power enabling a person to dispose of property as they think fit; property subject to a general power may be treated as part of that person’s IHT estate.

An illustration is Kempe v CIR (2004), where the deceased could redesignate policy beneficiaries at will and, failing designation, proceeds passed to his estate. He was held to have a general power over the policy; the proceeds were included in his IHT estate.

The three/seven year rules

When a policy is assigned into trust, this is a lifetime transfer for IHT purposes. The survival rules differ depending on the type of transfer:

• PETs (e.g. gift to a bare trust/individual): if the donor survives seven years from the gift, it falls out of account. If the donor dies within seven years, the value transferred becomes chargeable; taper relief reduces tax after three years.
• CLTs (e.g. assignment to a discretionary trust): a lifetime charge may arise if the value exceeds the available nil rate band. If the settlor dies within seven years, additional tax on death can be due. Taper relief can reduce the additional tax.

Key Term: potentially exempt transfer (PET)
A lifetime gift to an individual (or bare trust) that is exempt if the donor survives seven years, but chargeable if they die within that period.

If the settlor is primarily liable for any IHT due on a CLT and fails to pay, HMRC can pursue the trustees for unpaid lifetime tax. Any additional IHT arising on death in connection with a CLT falls on the trustees.

Nominated policies and pension death benefits

Some policies (such as group life cover or death-in-service benefits) allow the member to nominate a beneficiary. In many occupational schemes, the benefit is held under a discretionary trust; the member’s nomination (often called an “expression of wishes”) guides but does not bind the trustees. Where trustees exercise their discretion to pay to beneficiaries, the benefit bypasses the estate. Not all schemes operate this way: check scheme rules, as some death benefits may be payable to the estate.

Key Term: nomination
A direction or expression of wishes by the policyholder/member asking the insurer or trustees to pay the benefit to a named person; binding effect depends on the product and scheme rules.

In addition, statutory nominations exist for certain friendly society and National Savings-type products.

Key Term: statutory nomination
A nomination under specific legislation (e.g. for friendly societies, National Savings Bank, National Savings Certificates) allowing payment on death to the nominee directly, typically up to a prescribed monetary limit.

For friendly societies, the National Savings Bank, and National Savings Certificates, a written nomination can direct payment to a chosen person without a grant, up to the statutory cap (commonly £5,000). These sums do not pass via the estate for succession; the IHT position depends on ownership at death (these nominations are not trusts in the same way as policy trusts, but they direct payment outside probate).

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, providing prompt liquidity for dependants (e.g. mortgage repayments).
• The proceeds are not part of the IHT estate if the trust is effective and there is no reservation of benefit or general power causing inclusion.
• The funds are protected from claims by estate creditors, as they do not vest in the personal representatives (subject to potential challenge if created to defraud creditors).

From a practical standpoint, if IHT on the estate is payable before the grant, liquidity can be problematic. Where there are outside-the-estate receipts (e.g. trust policy proceeds or survivorship on a joint account), those recipients may be well placed to lend funds to the estate temporarily to enable the grant, to be repaid from estate assets after the grant. This can be a pragmatic solution where the Direct Payment Scheme from a bank account is unavailable or insufficient.

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. Although the assignment into a discretionary trust was a CLT at the time of creation, no additional death tax arises on the proceeds themselves as they are outside Aisha’s estate.

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 or the retention of a general power. The proceeds are treated as part of his IHT estate.

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 if the scheme allows binding nominations. In many occupational schemes, the trustees have discretion and will usually follow the expression of wishes; in either case, if the trustees exercise a discretionary power, the payment bypasses Clara’s estate for succession and IHT purposes.

Worked Example 1.4

Derek assigns an existing term assurance (no surrender value) into a discretionary trust for his partner and children. He dies eight months later. What are the IHT consequences?

Answer:
The assignment was a CLT. Because the policy had negligible value at the date of assignment, there was no lifetime IHT charge and, on Derek’s death within seven years, there is no additional IHT on the trust due to the low value transferred. The policy proceeds are outside Derek’s IHT estate. Trustees will not face periodic or exit charges if they distribute promptly and the hypothetical rate at entry was nil.

Worked Example 1.5

Ella assigns an endowment policy with a surrender value of £12,000 into a bare trust for her adult son and continues paying £200 per month premiums until death four years later. What is the IHT position?

Answer:
The assignment to a bare trust is a PET of £12,000 (valued under s.167 by reference to the surrender value/cost of provision). If Ella survives seven years, it falls away; if she dies within seven years, the failed PET becomes chargeable, with taper relief potentially reducing tax after three years. The ongoing premiums are transfers of value; they can be exempt if they qualify as normal expenditure out of income. The policy proceeds are outside Ella’s estate, as she retained no benefit.

Worked Example 1.6

Farid writes a policy into trust but reserves the power to substitute beneficiaries at will and, failing appointment, the policy is payable to his personal representatives. He dies six years later. Included for IHT?

Answer:
Yes. Farid retained a general power to dispose of the policy benefits, and default to his estate reinforces that control. As in Kempe v CIR, the policy proceeds are treated as part of his IHT estate notwithstanding the trust form.

Worked Example 1.7

Grace’s employer operates a death-in-service scheme under a discretionary trust. Grace completed an expression of wishes naming her sibling. On death, the trustees decide to divide the benefit between the sibling and Grace’s minor child. Does this affect IHT or succession?

Answer:
No IHT arises on the deceased’s estate from the scheme payment, which is within the trustees’ discretion and bypasses the estate. The expression of wishes is non-binding; the trustees’ discretionary payment does not pass via the PRs and is outside the succession estate.

Worked Example 1.8

Hari created a discretionary trust of a policy with negligible value. On Hari’s death, the trust receives £300,000 and pays it out to beneficiaries three months later. Is there an IHT exit charge?

Answer:
The exit charge is calculated by reference to a hypothetical periodic charge at the last ten-year anniversary (or at entry). As the entry value was negligible, the hypothetical rate is likely 0%. The apportioned exit charge is therefore nil; distribution shortly after death typically produces no trust-level IHT.

Worked Example 1.9

Imogen holds National Savings Certificates and makes a statutory nomination in favour of her niece. She dies owning £4,000 of certificates. How is payment made?

Answer:
The Certificates are paid directly to the niece on production of the death certificate and any required claim, without a grant. The amount does not pass via the estate for succession. For IHT, the value is still part of Imogen’s IHT estate because she owned the Certificates at death.

Worked Example 1.10

Jun died with a policy not in trust. His will leaves the estate to his spouse. Are the proceeds taxed?

Answer:
The proceeds are paid to the PRs, form part of Jun’s IHT estate, and then pass to his spouse. The spouse exemption applies so no IHT is payable, but the proceeds are delayed until after the grant, unlike a trust arrangement.

Exam Warning

If a policyholder writes a policy into trust but continues to benefit from it (e.g., by accessing cash/surrender value, retaining a right to revoke or change beneficiaries, or where proceeds default to the estate), the proceeds may be treated as part of the IHT estate. Also, do not assume all assignments into trust are PETs: gifts to discretionary trusts are CLTs. Always identify (1) the trust type, (2) any reserved powers/benefits, and (3) the timing and value of the transfer.

Revision Tip

Focus on the requirements for effective exclusion of policy proceeds from the IHT estate: (1) valid trust or nomination, (2) no reservation of benefit or general power, (3) correct classification of the transfer (PET vs CLT) and survival for seven years for PETs, and (4) apply s.167 on valuation and the normal expenditure out of income exemption for ongoing premiums.

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 (express or MWPA s.11) or validly directed under scheme rules/nomination.
• The type of trust (bare, discretionary, interest in possession) affects control and IHT: bare trusts are PETs on assignment, discretionary trusts are CLTs within the relevant property regime.
• When an existing policy is assigned into trust, value it under IHTA 1984 s.167; ongoing premiums may be exempt as normal expenditure out of income.
• If the policyholder retains a benefit or a general power, the proceeds may be included in the IHT estate (gift with reservation of benefit; general power analysis).
• Assignment of a policy into a discretionary trust is a CLT; lifetime and death charges are determined by trust type, value at transfer, survival, and taper relief. Additional tax on death (for CLTs) falls on trustees.
• Discretionary policy trusts can face relevant property periodic and exit charges, but these are often nil or minimal if the fund was of negligible value at entry and is paid out soon after death.
• If the policy is not written into trust, proceeds are paid to the PRs and form part of the IHT estate (subject to exemptions), with probate-related delays.
• Pension scheme death benefits are frequently held on discretionary trusts; an expression of wishes is typically non-binding and payments bypass the estate.
• Statutory nominations can direct certain friendly society/NS&I-type property (up to limits) outside the probate process; such sums still form part of the IHT estate if owned at death.
• Policy proceeds paid outside the estate are generally not available to estate creditors; however, anti-avoidance rules may apply if arrangements were made to defraud creditors.
• Distinguish carefully between the succession estate and the IHT estate; some assets pass outside succession but are still taxed for IHT (e.g., gifts with reservation of benefit).

Key Terms and Concepts

• estate
• writing a policy into trust
• assignment
• Married Women’s Property Act trust (MWPA trust)
• bare trust
• discretionary trust
• interest in possession trust
• relevant property trust
• inheritance tax (IHT)
• chargeable lifetime transfer (CLT)
• normal expenditure out of income
• gift with reservation of benefit
• general power
• potentially exempt transfer (PET)
• nomination
• statutory nomination