What is the Rysaffe principle?

What is the Rysaffe principle?

The Rysaffe principle is a technicality that comes with life insurance and Trusts, and it’s all to do with potential tax charges on life insurance claims.  

If we take everything down to it’s the very basics. Life insurance claims can be taxed if the policy isn’t put into what is known as a Trust. The value of the life insurance is added to the deceased’s estate and if it puts the value above the Inheritance Tax Threshold there can be tax.

So, for a very long time it’s been best practice to put life insurance policies into Trust. This does a couple of things. It means the beneficiaries of the Trust get the money far more quickly and keeps the claim away from the estate, which also means that the value is not added to the estate value. Perfect.

Each life insurance policy has it’s own nil rate band of £325,000 and HMRC can potentially charge tax on life insurance claims above this amount at certain times.

These charges can only happen at certain times and the chance of it happening is very low, but even so, there are certain steps that can be taken to avoid this which we will go through now.

The Rysaffe principle

It’s name comes from Rysaffe Trustee Co (CI) versus Inland Revenue Commissioners case, in 2003. I’m going to give a very quick summary of what happened:

• Instead of arranging one large insurance policy in one Trust, five lower value policies were arranged over five different days to avoid the potential tax on the claim
• IRC argued that this was the same as doing one large policy
• The IRC lost their argument and there was no charge on the life insurance claim

This led to the Rysaffe principle becoming a technical term in life insurance, that has caused confusion for many people and advisers alike. Essentially, the principle is that if you currently set up life insurance policies with a value of £325,000 or less, into Trust on different days, the periodic charges won’t apply.

Life Insurance Trusts

There are quite a few different Trusts that can be used for life insurance policies. For this blog I am talking about pure protection life insurance policies. This means that there is no investment or cash-in-value at the end of the policy.

Here are some common Trusts:

• Discretionary Trust – the life insurance policy is placed into a Trust and you can name who you want to receive a claim or leave it to a standardised list such as spouse, children etc. With a discretionary Trust the people who you assign to manage where the claim goes can choose and potentially vary who receives the money.
• Split Trust – this is usually used for life insurance and critical illness policies that are combined together. This Trust is set up to make sure that the person that is insured receives a pay out from a critical illness policy, and the life insurance goes to who you want it to.
• Absolute Trust – this kind of Trust is usually avoided, but does have its place. Once it is made there is no flexibility in who receives the money once you have set up the Trust.

Helpfully (sarcasm), insurers all have different Trusts and different situations that they refer to. You can use a discretionary Trust with one insurer and then look at one with a different insurer and the rules in them aren’t the same.

Rysaffe in Practice

Let’s look at an example.  We have a life insurance policy of £500,000 set up all in one go, in one Trust on 1 July 2014. There has been a claim on the policy and the life insurance pay out is sat in the Trust on 1 July 2024.  The family haven’t moved the money out yet, they are still coping with the loss of their loved one and handling funeral arrangements etc.

The problem is that the money is now sat in the Trust on the day of the 10th anniversary of the policy going into Trust. It’s all about this 10 year periodic charge, so the same applies at year 20, 30 etc. It means that the family face a tax charge of 6% on anything over the £325,000 nil rate band that is allowed on the Trust. This is a charge of £10,500.

If the life insurance had been arranged as £325,000 and £175,000 in two policies, put into Trust on two different days, the tax charge would not be there. 

So why isn’t all insurance set up this way? The reason usually is that it usually costs more to arrange two policies rather than one. The difference can be £1 or £2 a month, but it can become much more than this and I’ve seen it where it can be £50 per month more to do multiple life insurance policies instead of one.

It then becomes a choice of do you want to pay more for the cover now, or are you happy for part of the claim to cover the tax in the very unlikely event that the claim pay out happens to coincide with this 10 year anniversary. A lot of people choose to go with one life insurance policy, one direct debit going out, one policy number, everything with the same insurer. 

The key thing is making sure that you and the person that you want to receive the money know about this rule and decide what is best for your situation.

Large Value Life Insurance Plans

There are times when the tax charges can come into play for very large life insurance plans, often whole of life insurance plans.  As well as the tax if there is claim payout sat in the Trust at the 10 year anniversary, there can also be tax even if the person hasn’t died.

Bear with me.

There can be tax due if on the 10, 20, 30 year anniversary the premiums paid towards the life insurance exceed the nil rate band of £325,000. It’s really important when considering this that indexation or reviewable premiums could put someone into these charges without them realising it.

There can potentially be some other charges too, but the key thing is the value of the premiums paid in over time.

Terminal Illness Cover

There is something extra that comes with life insurance: Terminal Illness Cover. It means that if you are diagnosed with a terminal illness and less than 12 months left to live, the insurer will pay the life insurance policy out early to you while you are alive. Some older life insurance policies used to say 18 months.

Well, HMRC may have eyes on this too. Let’s look at an example and this will be quite a sad scenario to discuss. You have life insurance and it has been in Trust for 9 years and 10 months. You are told that you have terminal cancer and likely have a couple of years at most to live. 

You might decide not to claim on the terminal illness benefit, it could be too much to fact that reality. It’s also very hard to get a diagnosis of less than 12 months left to live, medical specialists are quite reluctant to state this and it does mean that a lot of terminal illness claims are postponed.

You do end up passing away when the life insurance policy has been in Trust for 10 years and 11 months. HMRC can potentially look at this claim and try to tax it, stating that you should have claimed for the terminal illness cover which would have meant that the value of your estate was more upon your death. Unfortunately, there are situations where this has happened and HMRC has taken the steps to tax the life insurance pay out.

For many people arranging life insurance the need to be mindful of the Rysaffe principle is not relevant. Life insurance is often linked to mortgages and many people have mortgages that are less than £325,000. It is also often linked to multiples of salary  (usually 3 to 5 times the annual income) and many people are well within the nil rate band for the Trust.

However, for some people understanding and knowing how to apply the Rysaffe principle to life insurance policies can be a valuable way to protect against periodic tax charges on the Trust. If it’s something that is a concern to you our advisers will help you to arrange your life insurance in a way that works best for you. 

Our award winning advisers will talk you through your insurance options and help you get the life insurance that you and your family need.

Related blogs