A life assurance policy allows the policyholder to specify one or more beneficiaries, who will receive the policy proceeds on the death of the policyholder. It is not uncommon for a married policyholder to nominate his or her spouse as beneficiary. This is usually done with the intention that the surviving spouse will then invest the policy proceeds to generate sufficient income to meet the ongoing financial needs of the survivor and their children.

Normally the payment of the proceeds of a life policy is tax-free; the same will not necessarily apply to the subsequent income and capital gains earned on the investments made with the proceeds.

One of the drawbacks of having the surviving spouse receive and then invest the policy proceeds is that from then on any taxable income earned on the invested proceeds (e.g. interest or rentals) and any subsequent taxable capital gains made from the invested proceeds (e.g. selling of shares or unit trusts) by the surviving spouse are taxed in the survivor’s hands. This will be the case even though the survivor is likely to be applying a large portion of the income earned on invested assets towards the accommodation, food, schooling and other needs of the couple’s minor children. The payment by a taxpayer of his or her children’s maintenance expenses is simply not tax deductible from the parent’s income.

A more tax efficient option to consider is for the policyholder to leave some or all of the proceeds to a trust. Such a trust could be either a trust set up by the policyholder is his or her will (called a testamentary or Will trust) or a trust created in a trust deed during the lifetime of the policyholder (called an inter vivos trust).

Trust income is taxed on a “conduit principle” i.e. if taxable income earned by a trust is awarded by the trustees to a beneficiary, then it retains its identity (e.g. as interest or rentals) and if it is awarded in the same tax year then it is taxed in the hands of the beneficiary and not in the hands of the trust. For example, a trust beneficiary who receives interest from a trust will be liable to declare the interest earned but may claim the annual tax free exempt portion on interest available to all taxpayers.

A trust structure thus provides an opportunity for the tax burden on taxable income earned by the trust to be split amongst the surviving spouse and children. Bear in mind that as young children are unlikely to be earning any other income, at current 2012/13 tax thresholds each child could to awarded up to R63,556 in taxable income without being liable to pay any income tax.

By incorporating a trust into an estate plan, one may be able to leave behind a more tax efficient structure, resulting in a greater net income for loved ones. However, trust laws are complex and it is recommended that one seeks specialised financial and legal advice whenever a trust structure is considered in one’s estate planning.