According to figures from the 2009/2010 tax year, families who have lost a loved one face up to 40% inheritance tax (IHT) on life insurance payouts. 

However, experts say policy holders can stop their loved ones being hit with a big IHT bill by writing their policies into a trust.

Writing a life insurance policy into a trust means final payouts will not form part of an individual’s estate when they die, meaning the payout is not liable to IHT.

The money will also be paid out quicker because families will not have to wait for the estate to be settled. In some instances, life insurance payouts can take months to be settled – a problem if the deceased’s estate still has monthly outgoings like mortgage payments.

Sean McCann, personal finance specialist at NFU Mutual, said: “Life insurance policies should, wherever possible, be written into a trust to prevent a significant chunk going to the taxman. Otherwise, up to 40% of the payout could be claimed in inheritance tax.

“What’s more, trusts are really simple to set up and, with most life insurance companies providing the forms free of charge, it shouldn’t cost anything other than spending a little extra time to complete.”

Many policy holders blame the extra-paperwork for not writing their policies into a trust, however this could mean the difference of an average £35,000 in the final payout.

Peter Chadborn, director and adviser from Plan Money, says: “Life insurance itself has been really commoditised in recent years like car insurance or house insurance; policy holders think they just need to get one and that’s the end of it, without perhaps understanding the effect of IHT.

“It’s often seen as unconnected to inheritance and often people just don’t know enough about life insurance and what it really means.

“However, when it comes to advisers, there are two reasons as to why they wouldn’t bring it up – sometimes they think it’s out of their remit. They think they don’t want to get it wrong so they don’t bring it up. I think that’s a cop out.

“And then there are some advisers who see a trust as a whole chunk of extra work and try and avoid it if they can.” 

Those with life insurance policies in a trust are being urged to check that the terms of the trust are still relevant to the individual’s personal situation.

Often policies will have been written many years ago and there will be many people who will have remarried or changed relationships in that time but never reviewed their trust – in these instances if the trust is not changed, ex-spouses could be set for unintended windfalls if paperwork is out of date.

Chadborn advises: “Whether you’ve gone the DIY route, make sure you ask for information from your provider. If you have gone the adviser route, make sure you ask.

“Ask your adviser if they can advise you on trusts, and if they say no – go and find another adviser. And for DIY routes make sure you read the terms carefully because you have nobody to blame other than yourself if something goes wrong.

“One tip I have for everyone is make sure you don’t keep putting it off.”

HOW TO PROTECT YOUR ESTATE FROM THE TAXMAN AFTER YOUR DEATH:

Writing life insurance policies into trust is just one example which could save people thousands of pounds.

Here are a few simple steps that people should be taking to make sure they’re not paying more tax than they have to.

Make sure your life insurance policies are written in trust:

• You could end up giving up to 40% IHT to the tax man on your death

• Simple to do – many life insurance providers will provide you trust documentation free of charge.

• Has the added benefit of speeding up payment in the event of a claim.

• Take advice to make sure you get the right type of trust for you, and help protect your wealth 

Move investments around the family

• The point at which 40% income starts to bite has fallen from £42,475 to £41,450, meaning that many people are paying higher rate tax for the first time.

• If you’re paying 40% income tax (or even 45% if your income is over £150,000) and your spouse or civil partner is a 20% or non-taxpayer, it can make sense to move income producing assets such as savings accounts or investments into their name.

• If you’re cashing in shares or other investments, it can make sense to transfer some or all of it to your spouse. Get the right advice before you take action

• All you need to take advantage of this tax break is a little bit of trust in your spouse!

Preserve your child benefit with a pension contribution

• If your income is over £50,000, you will face an extra tax charge that is designed to take back some or all of your child benefit.

• For every £100 of income you have over £50,000 you will lose 1% of your child benefit. At £60,000 you will lose all of it.

• This can be worth £1752 each year if you have 2 children, or £2449 if you have 3.

• The income looked at is your ‘Adjusted net income’ which is arrived at after deducting pension contributions.

• If you’re in your employer’s pension scheme, you and your employer can also make National Insurance savings by opting for salary exchange or ‘smart pensions’

Use your ISA allowance

• The most simple tax planning you can do

• An ISA is a shield you wrap around your cash or investment to protect it from income tax and capital gains tax.

• You can wrap this shield around cash in a savings account (up to £5,760 this tax year) or share based investments.

• The allowance for this tax year is £11,520 that’s £23,040 for a married couple. Over 5 years a married couple could invest over £115,000 sheltered from additional income tax and capital gains tax.