Saving on IHT Through Discretionary Trusts

The Inheritance Tax (IHT) nil rate band has remained static for over ten years now. During this time, property prices and investment values have continued to rise. This means that IHT, once only a consideration for the very wealthy, is now affecting many more families.

Discretionary Trusts are one method of reducing your IHT bill, passing on money to your family, and keeping some control over your hard-earned wealth.

What is a Discretionary Trust?

A Trust allows you to ring-fence assets, such as cash, investments, or property, for the future use of your beneficiaries.

There are three main parties to the Trust:

• The Settlor – the person who makes the original gift.
• The Trustees – who have responsibility for managing and distributing the Trust’s assets.
• The Beneficiaries – the individuals who will receive income or capital from the Trust.

Normally, the Settlor will be one of the Trustees. It’s important to appoint at least one other person as a Trustee, as they will be able to look after the Trust if the Settlor is no longer able to.

To be effective for IHT planning, the Settlor should not be able to benefit from the Trust.

A Discretionary Trust allows the Trustees to have the final say over how the Trust funds are distributed. It is more flexible than an Absolute Trust, which designates a specific amount to each beneficiary. However, it is significantly more complicated, and there can be tax implications.

Tax Treatment of Discretionary Trusts

The taxation of Trusts can be complicated, but the main implications are:

Inheritance Tax (IHT)

• The gift into Trust is a Chargeable Lifetime Transfer (CLT). If this gift, and cumulative gifts over the past seven years, are over the nil rate band (￡325,000), an immediate IHT charge of 20% applies.
• If you die within seven years, the gift is added back into your estate, and incurs a further IHT charge of 20%.
• After the full seven years have elapsed, the gift is outside your estate and will reduce your IHT liability.
• However, further IHT charges may apply within the Trust. If the value exceeds the nil rate band at the ten-year anniversary, IHT of 6% is charged on the excess.
• Proportional IHT charges will also apply if any capital is distributed from the Trust after the ten-year anniversary.

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Income Tax

• If the Settlor is still alive, Trust income is taxed at their marginal rate.
• After the Settlor’s death, the first ￡1,000 of Trust income is taxed at the basic rate, i.e. 20% for most types of income and 7.5% for dividends.
• The remainder is taxed at 45% for most income and 38.1% for dividends.

Capital Gains Tax (CGT)

• The Trust has a CGT exemption equivalent to half the personal exemption. The full exemption is currently ￡12,300, which means that Trusts have ￡6,150 to set against gains realised.
• The exemption is split between Trusts set up by the same Settlor. So if you set up two Trusts, each one would have an exemption of ￡3,075.
• CGT of 28% is charged on any gains above this exemption.

The Trust Assets

You can either place existing assets into Trust, or make a cash gift for the Trustees to invest.

You can also designate life policies and death in service benefits into Trust. This means that the policy benefits are paid outside the Settlor’s estate, and no immediate IHT applies.

Many Trusts hold investment bonds. These work well with Trusts, for the following main reasons:

• Placing an existing bond into Trust does not have immediate income or capital gains tax implications. It may incur IHT if the value is over the nil rate band.
• Bonds have an annual withdrawal allowance of 5% per year, which can be carried forward to future years if it is not taken. This means that the Trust can produce an income for the beneficiaries without incurring tax.
• Tax only applies if the bond is fully or partially encashed. This makes it easier for the Trustees to administer as there is no need to complete an annual tax return.
• The bond is divided into segments. Segments can be assigned to beneficiaries before they are encashed. This means that the gains are taxed at the beneficiary’s rate rather than the (usually higher) Trustee rate.

Trusts can also hold investment accounts, shares, and property. However, these would generate an income, and potentially capital gains if the assets are sold. Tax advice would always be recommended.

How Could a Discretionary Trust Benefit You?

The main benefits of a Discretionary Trust are:

• The capital will drop out of your estate after seven years.
• Any growth on the investment will accumulate in the Trust, rather than in your own estate.
• You can still retain some control over the money, rather than making an outright gift.
• Your legacy is protected if any of the beneficiaries get divorced, are declared bankrupt, or lose capacity.
• The Trust funds are not considered to be in the estate of any of the beneficiaries. This can help with intergenerational wealth planning.

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Disadvantages

Of course, there are some downsides to setting up a Trust:

• To be effective for IHT planning, the assets must be out of your reach. It’s important to consider the affordability of any gift and ensure you will have enough money to live on.
• The IHT benefit only applies if you survive for seven years after making the gift.
• If you die within seven years, any gifts made within the previous seven years are also added back into your estate.
• Trusts are taxed at a higher rate than personal investments.
• IHT charges may apply at outset, at ten-yearly anniversaries, and when capital exits the Trust.
• If you require long-term care, placing money in Trust could be considered deliberate deprivation of assets. This means that while you cannot actually access the money, it will be counted in your means test, and may reduce your eligibility for help with your care costs.

What Are the Other Options?

Trusts are not the only option for mitigating IHT. Some other potential solutions are:

• Making outright gifts. Smaller gifts are likely to be covered by annual gifting exemptions. Larger gifts will drop out of your estate over seven years.
• Claiming Business Relief. If you own a business, shares in a private company, Alternative Investment Market (AIM) stocks, or an Enterprise Investment Scheme (EIS), the assets can receive IHT relief of 100% after just two years. However, these investments can be very risky.
• Insuring the liability. If you set up a whole of life plan in Trust, this could provide a sum, outside your estate, for the Trustees to settle any IHT bill.
• Setting up a Family Investment Company. This can be effective for larger estates, but it is complicated, and specialised tax advice is recommended.

A combination of approaches, implemented over several years, often results in the best outcome. A financial planner can help you determine the most efficient way of passing assets to your loved ones, while ensuring your own needs are taken care of.

Disclaimer: The information provided in this blog post is for educational purposes only and should not be considered as financial advice. Consult with a qualified financial adviser before making any investment decisions.

The Financial Conduct Authority (FCA) do not regulate Inheritance Tax Planning, Tax and Trusts.

The benefits to the treatment of tax will depend on your individual circumstances and may be subject to change in future.

The value of investments and the income they produce may go down as well as up. You may get back less than you originally invested

Pensions are a long-term investment. You may get back less than you originally put in. Pensions are subject to tax and regulatory change, meaning the tax treatment of pension benefits can and may change in the future.

Figures correct at time of writing.