How can life insurance improve estate planning?

• Two things are said to be guaranteed: death and taxes

• Having the right insurance policies in place can provide invaluable relief to your loved ones

• Especially at a time when they are at their lowest

Putting your legacy in place is a really important part of financial planning and life insurance can play a number of roles, particularly if you should pass away suddenly and/or prematurely.

Irrespective of age and physical health, the unforeseen can happen to any one of us at any time. Having the right policies in place can potentially make the difference between your grieving loved ones being taken care of, at least financially, or facing the additional anxiety of how they will pay the bills.

How does life insurance work?

There are two ways in which you can insure your life. One is called life assurance and the other is called life insurance.

What’s the difference? Well it lies in the subtle difference between the words “assure” and “insure”. We are all guaranteed to die at some time and the term ‘assurance’ reflects this: the insurer is guaranteed to have to pay out. This type of policy is therefore also known as “whole of life cover” as it will stay in place for the rest ("whole") of your life.

But the word “insure” means “just in case”. This type of policy will only cover your life for a set period of time. For this reason it is also known as “term insurance”

Because of this difference in the risks the life insurer faces, whole of life policies tend to be more expensive than term insurance policies.

The different types of term insurance

As we have seen, term insurance policies are designed to provide temporary protection for a specified period of time.

There are three different types of term insurance to consider:

• Level term insurance pays out a fixed sum if you die during the term of the policy. For example, a £100,000 policy over a 40-year term will pay out £100,000 whether you die in year one or year 39.

• But over 40 years, the cost of living could increase quite markedly. With increasing term insurance, the pay-out rises in line with inflation or by a set amount each year. But you must bear in mind that your premiums will increase as your cover rises.

• Lastly, there is decreasing term insurance. This type of cover is commonly used in conjunction with a repayment loan, where monthly payments include an element that pays back the amount borrowed. This type of policy tends to be more affordable than level or increasing term insurance as the risk to the insurer reduces the longer the policy is in place.

Life insurance can leave your family debt free

Term insurance is usually taken out when you get a mortgage or other significant loan.

During the term of the policy any outstanding balance on the loan is paid off if you pass away. This can take an enormous amount of pressure off your loved ones during a very difficult time and can certainly help in maintaining financial stability.

Normally, life insurance pays out a lump sum. But if you have a child who requires lifetime care, or someone vulnerable who cannot manage their own finances, the policy can be written so that the proceeds are used to buy an annuity which pays out regular sums over time.

How do you use life insurance in an estate plan?

Life insurance payouts are free from capital gains and income tax. But as consumer champions Which? pointed out in June 2019, they are usually included in your estate for inheritance tax. They can therefore attract a chargeable gain of 40%.

You can make insurance payments totally tax free

However, writing your life insurance policy in trust means your estate won’t have to pay inheritance tax on any pay out. This is because the value of the life insurance policy does not count towards the value of your estate. Therefore, writing a life policy in trust can prove invaluable in estate planning. By nominating your children or grandchildren as beneficiaries, you can leave the bulk of the estate to your spouse tax free while ensuring your other loved ones can also benefit.

The trustees could be family members, friends or perhaps a solicitor. But they can’t be any of the named beneficiaries. The job of the trustees is to ensure that the assets contained within the trust go to the right people in the right proportions.

Read more: The role of trusts in estate planning

It can be easy to write an insurance policy in trust

Luckily, insurance companies offer the option of writing the policy in trust when you take it out and they generally don’t charge any extra for doing this.

You can also put a life insurance policy into trust at a later date, although it can be complicated and may incur some costs. The help of a financial adviser could be invaluable if you decide to take this route.

A trust can provide immediate access to funds

In the event of your death, your estate will be subject to probate, a process which can take many months. In the meantime, assets within the estate cannot be accessed by your family. This could leave them without any means of paying the bills

But funds from a trust-based life policy can be made available very quickly. Because the assets lie outside your estate, Legal and General advise that an insurer usually only requires a copy of the death certificate to pay out to the trustees. That money could be invaluable for covering both your family’s immediate day-to-day living costs and to pay for your funeral.

What are the disadvantages of writing the policy in trust?

Writing an insurance policy in trust can make it difficult to make any changes– such as the intended beneficiaries – because you no longer own it. That’s what puts the policy outside your estate. It is not impossible to amend a policy in trust but you might invalidate your cover. Taking professional advice could really help here.

While writing the policy in trust will take the proceeds outside your estate for IHT purposes, creating the trust itself could trigger an IHT liability if you die within seven years of putting the trust in place or if the beneficiary is not your spouse or civil partner.

Life insurance could reduce your estate’s inheritance tax bill

When planning your legacy, one option is to give assets away while you’re still alive. Whilst this has the potential to reduce your estate for IHT purposes, you have to live for seven years after making the gift. If you die before then your estate will have to pay inheritance tax on the gifts.

Read more: Intergenerational wealth transfer; it's all the rage

However, the amount of IHT your estate has to pay on the gifts reduces over the seven years. It decreases from 40% if you die within three years of making the gift, down to 8% if you die in the seventh year. You can find out more about this on the Money Advice Service’s website here.

So, depending on your individual circumstances, you could take out a seven-year decreasing term policy that matches the IHT liability of your gift(s). This could be a relatively cost effective way of ensuring your loved ones receive as much of your estate as possible.

What do I need to think about?

What approach you take will depend on your individual circumstances.

All life insurance policies must have an owner. This is usually the insured, their spouse or their children. Each choice has advantages, disadvantages, and tax implications. You need to think about whether the policy insures just one life or joint lives. A joint life policy generally pays out on the death of the first partner. Because there will only be one pay-out, these policies are usually cheaper than each partner buying an individual policy.

But if your plan is to leave all your assets to your spouse tax free, it can make sense to have the policy pay out on the second death when any inheritance taxes fall due. The second partner would also be left without life cover and arranging a new policy later in life can be more costly as this article from Investopedia explains.

A policy also needs a named beneficiary or beneficiaries and this is the most important decision you can make. Usually this will be your spouse, children, or other dependents. But choose carefully as they can use the money how they want even if you intended the money to be used to settle estate taxes.

You can also nominate a second beneficiary in case you and your primary beneficiary die together. You can even nominate a charity.

As well as protecting your loved ones should the worse happen, there are also things you can do to protect your lifestyle should you become incapacitated or seriously ill. Read our companion article Do you need income protection? for more details

Make sure your beneficiaries remain current

Don’t forget to change your beneficiaries in response to big life events. While you might want to remove a divorced partner as a beneficiary, you need to consider whether your children could suffer if child maintenance payments stopped due to your death.

Making the right decisions

The amount of cover you need will depend on many things including why you want to take out a particular type of policy and your current financial status. As you age, you might find the level of cover you require declines as you spend your accumulated wealth. Or perhaps it changes from a short-term need to something more permanent.

Determining what type of insurance is most suitable for your situation, and exactly how much cover you need can be complex. It’s therefore best to speak to a financial adviser to make sure you have the right policies for your circumstances and needs.

You should also talk your decisions through with your family so everyone is clear what you hope to achieve with your legacy. Letting your beneficiaries know who has been nominated and why could help dissolve a lot of squabbling when you are no longer around to explain your intentions.