Discretionary Trusts for Life Insurance: A Practical Guide

A life insurance policy not held in trust is an incomplete piece of financial planning. Without a trust, the sum assured falls into the deceased's estate, attracts inheritance tax, and cannot be released until probate is granted — a process that can take months and sometimes years. For high net worth individuals and internationally mobile clients with complex estates, the consequences of an untrusteed policy can be severe.

This guide focuses specifically on discretionary trusts for life insurance — why they are preferred over bare trusts in most circumstances, how they work in practice, and the trustee obligations that come with them.

Why Putting Life Insurance in Trust Is Essential

When you die, your estate must go through probate (or, in Scotland, confirmation) before assets can be distributed. This is a legal process that typically takes six to twelve months in straightforward estates and considerably longer in complex ones. During this period, the life insurance proceeds sit in limbo — they cannot be paid to beneficiaries until the estate is administered.

By placing a policy in trust, the sum assured sits outside the estate entirely. It is paid directly to the trustees, who can release it to beneficiaries within days of the death being confirmed to the insurer. This speed can be critical: a surviving spouse who has lost the family's main earner may need funds immediately to meet mortgage payments, school fees, and household costs.

Beyond speed, there is an inheritance tax advantage. Assets held in a discretionary trust at the date of death do not form part of the deceased's estate for IHT purposes, provided the trust was properly established and the settlor had no retained interest in the trust assets. For an estate that would otherwise face a 40% IHT charge, placing a £500,000 life policy in trust saves £200,000 in tax.

Bare Trust versus Discretionary Trust

Two types of trust are commonly used for life insurance:

A bare trust (also called an absolute trust) fixes the beneficiaries irrevocably at outset. Once established, the beneficiaries cannot be changed. This simplicity makes bare trusts easy to understand and administer, and the tax position is generally straightforward — the trust assets are treated as belonging to the beneficiaries for most tax purposes. The disadvantage is inflexibility: if a named beneficiary dies before the claim, or circumstances change (divorce, estrangement, birth of new children), the trust cannot be updated.

A discretionary trust gives trustees the power to decide which members of a class of potential beneficiaries receive the proceeds, and in what proportions. The class is defined in the trust deed — typically the settlor's spouse, children, grandchildren, and other dependants. No beneficiary has a fixed entitlement until the trustees exercise their discretion. This flexibility is highly valuable: the trust can adapt to changing family circumstances, and the settlor can update their letter of wishes at any time to reflect current intentions without changing the trust deed itself.

For most HNW clients, a discretionary trust is the correct choice. The flexibility to adapt distribution to circumstances that could not have been foreseen at outset — a child developing a disability, a beneficiary experiencing financial difficulties, changes in tax law — outweighs the slightly more complex administration.

Establishing a Discretionary Trust for Life Insurance

Most life insurance providers offer a standard discretionary trust form as part of their policy documentation. For straightforward family situations, this insurer-provided trust deed is adequate and avoids solicitors' fees. For complex estates, international connections, or particularly large sums, bespoke solicitor-drafted trust documentation provides greater certainty.

The trust is established by executing the trust deed. This must happen before, or simultaneously with, the policy inception. A policy that has been in force for some time can be assigned into trust, but the assignment is treated as a chargeable lifetime transfer for IHT purposes if the policy has significant value. For new policies, always establish the trust at outset.

The trust deed identifies:

• The settlor — usually the life assured, who establishes the trust and (via the employer or personally) pays the premiums.
• The trustees — at least two individuals (or one corporate trustee) who hold and administer the trust.
• The class of potential beneficiaries — typically defined broadly to encompass family members and dependants.

The settlor should not be the sole trustee of a discretionary trust. If the settlor is also the sole trustee, the arrangement may not be legally effective as a trust. The settlor can be one of two or more trustees, or can appoint independent trustees and step back entirely.

Trustee Duties and Obligations

Trustees of a discretionary trust carry fiduciary duties. They must act in the best interests of the beneficiaries, not in their own interests. Specific duties include:

Duty to act in accordance with the trust deed. Trustees must follow the terms of the trust document. They cannot distribute to individuals outside the defined class of beneficiaries.

Duty to consider all potential beneficiaries. When a claim is made, trustees must actively consider who should benefit and in what proportions. They cannot simply follow the settlor's letter of wishes without thought — they must exercise genuine independent judgement. In practice, most trustees do follow the letter of wishes unless there is a compelling reason not to, but the exercise of discretion must be genuine.

Duty to act unanimously (or by majority if the deed allows). If there are two trustees, both must generally agree on distributions. Disagreement between trustees can delay payment, so selecting trustees who are likely to act harmoniously is important.

Duty to keep records. Trustees should document their decisions — particularly why they chose to distribute in a particular way. A simple trustee resolution recording the decision is sufficient in most cases.

Duty of care in administration. If the trust holds assets other than cash (for example, if the life policy has an investment element), trustees must take reasonable care in managing those assets.

For most term life insurance trusts, the practical trustee work is minimal. The policy has no cash value during the insured's lifetime. The trust only becomes active on death, at which point the trustees receive the claim payment and distribute it.

Changing Beneficiaries in a Discretionary Trust

One of the key advantages of a discretionary trust is that the letter of wishes — which guides the trustees — can be updated at any time without legal formality. The settlor simply writes a new letter addressed to the trustees, superseding the previous one. There is no need to amend the trust deed, no insurer notification required, and no cost.

The class of potential beneficiaries (as defined in the trust deed) cannot be changed without amending the deed, which typically requires all trustees to execute a deed of variation. However, the class is usually defined broadly enough to accommodate most foreseeable changes — adding a new child to the class usually does not require a deed variation if the deed already includes "children of the settlor" rather than named children.

For significant changes in family structure — such as remarriage after divorce, or a wish to include stepchildren — reviewing the trust deed with a solicitor is advisable to ensure the desired beneficiaries are within the defined class.

The Spousal Bypass Trust

A spousal bypass trust is a variant of the discretionary trust used in IHT planning. In a standard approach, a surviving spouse would receive the life insurance proceeds, and on the surviving spouse's death, those funds would be part of their estate and potentially subject to IHT.

A spousal bypass trust holds the proceeds in a discretionary trust after the first death, rather than paying them directly to the surviving spouse. The trustees can make distributions to the surviving spouse during their lifetime (meeting the duty to consider all beneficiaries), but the assets are not legally the spouse's property and therefore not included in their estate on second death.

This structure is particularly effective where both spouses have significant estates of their own, or where an IHT liability on second death is anticipated. It requires careful trust drafting and ongoing trustee administration, and specialist advice is essential given the interaction with residence nil-rate band rules and the spouse exemption.

For internationally mobile clients, the spousal bypass trust may also have advantages in jurisdictions that apply forced heirship rules, as assets held in a UK discretionary trust may be treated differently from directly inherited assets under some civil law systems.

Inheritance Tax on Discretionary Trust Assets

Discretionary trusts are subject to their own IHT regime, separate from the estate of the settlor. There are three potential charges:

Entry charge — Where assets are added to a discretionary trust during the settlor's lifetime and the total chargeable transfers exceed the nil-rate band (currently £325,000), an entry charge of 20% applies to the excess. For life insurance policies held in trust, the value added to the trust is typically the surrender value at the date the trust is established — which for pure term insurance is nil or negligible. No entry charge arises in most cases.

Ten-year anniversary charge — Every ten years, the trust is subject to a periodic charge of up to 6% of the trust's value above the nil-rate band. If the trust is paid out before the ten-year point (as is usual for life insurance trusts — the claim is made, funds distributed, and the trust wound up), this charge never arises.

Exit charge — Where assets leave the trust before the first ten-year anniversary, a proportionate exit charge (up to 6% of the value) may apply in theory. For life insurance trusts where the entire fund is distributed promptly following a claim, the practical charge is very small and in many cases negligible.

In practice, the IHT regime for life insurance discretionary trusts is benign. Most term insurance trusts pay out, distribute, and wind up without ever incurring a meaningful IHT charge at trust level.

International Considerations

For internationally mobile clients — those resident outside the UK or holding assets in multiple jurisdictions — the choice of trust jurisdiction matters. A UK discretionary trust governed by English law is familiar to UK advisers and insurers, but may not be recognised in the same way by the legal systems of countries with civil law traditions.

Some clients prefer to hold international life insurance policies in offshore trusts established in jurisdictions such as Guernsey, Jersey, the Isle of Man, or Cyprus. These trusts may offer:

• Favourable treatment in multiple jurisdictions
• Flexibility for beneficiaries in different countries
• Professional trustee services with international capability
• Potential exclusion from UK IHT on non-UK assets for settlors who are not long-term UK residents (the residence-based test that, from 6 April 2025, replaced the former domicile-based excluded property rules)

The interaction between trust structures and the UK IHT changes that took effect from 6 April 2025 — which replaced the old domicile-based system (including the former "deemed domicile" rules and the remittance basis) with a residence-based regime for inheritance tax — makes international trust planning complex. Specialist advice tailored to your specific residence position is essential.

Trustee Capacity: When to Appoint a Professional Trustee

Individual trustees — typically a spouse and a trusted friend — are appropriate for straightforward family trusts. For larger sums, complex family structures, or international estates, a professional trustee adds several advantages:

• Expertise in trust administration and decision-making
• Continuity (professional trustees do not die, emigrate, or become incapacitated)
• Neutrality in family disputes
• Regulatory oversight (professional trustees in many jurisdictions are regulated and bonded)

Professional trustee services are typically charged as a percentage of assets or a fixed fee. For a large life insurance trust that will be wound up relatively quickly after a claim, the cost is modest relative to the benefit of having expert, neutral administration.

How Global Investments Can Help

Global Investments advises HNW clients and internationally mobile professionals on the correct trust structure for their life insurance arrangements. We review existing policies to identify those without trust, advise on trust type, help select and brief trustees, and coordinate with solicitors where bespoke deed drafting is required.

For clients with international connections, we provide advice on offshore trust structures and the interaction with UK and foreign tax systems. If you have significant life insurance cover and are uncertain whether it is correctly held in trust, contact us for a review.

This guide is for information only and does not constitute regulated financial advice. Trust law and tax treatment are complex and depend on individual circumstances. Seek independent professional legal and financial advice before establishing any trust.