Inheritance tax (IHT) was once considered a tax for the rich. But this assertion is beginning to change. Rising asset prices, coupled with frozen tax-free thresholds, is nudging more and more estates into IHT territory.
Those with an IHT problem often have a tricky balance to strike; sheltering as much of their estate from HMRC as possible while continuing to enjoy a financially secure retirement.
But striking this balance isn’t easy, largely due to the number of unknown variables at play. Health, inflation rates, stock market performance, and tax are all subject to change over time. In the absence of sound and diligent financial planning, any decisions your clients make today could have implications further down the line.
One of the most effective and popular solutions to reduce IHT is using trusts, which enable individuals and families to move assets outside of their estate without losing full control of them.
In this article, we focus on a particular type of trust, the discounted gift trust, and explain how it can help your clients plan their future wealth effectively.
But first, let’s examine why such trusts are likely to play a key role over the coming years.
Although only one in 25 deaths result in IHT being paid, government receipts are rising sharply. Between 1 April 2021 and 31 March 2022, HMRC pocketed £6.1bn in IHT payments, a £0.7bn uptick on the previous 12 months. This is far from a recent trend. Annual IHT payments have almost tripled since 2010.
The combination of the nil rate band and residence nil rate band being frozen at £325,000 and £175,000, respectively, until 2026, and toppy property valuations, means clients’ IHT bills will continue increasing over the coming years.
With billions of pounds set to pass from one generation to another over the next few decades as part of the Great Wealth Transfer, trusts have an increasingly important part to play in minimising IHT.
Clients who are concerned that making outright gifts might leave them short on income either now or in the future, but are equally worried that retaining assets would lead to a hefty IHT bill, might find the answer in a discounted gift trust.
This is a planning arrangement to help your clients move investable capital outside on their estate, while still retaining the right to draw a regular income. The discount means IHT relief can often be immediate.
The settlor (or settlors if joint) pays a lump sum into the trust and selects the people they wish to benefit. This money is placed into an investment bond (either onshore or offshore) at a suitable level of risk, with the settlor then choosing a set level of withdrawals. After seven years, the value of the gift is outside of the estate.
These withdrawals must be made for the remainder of the client’s lifetime or until the payments have been exhausted.
To work most effectively, any withdrawals should be spent by the settlor to avoid remaining in their estate. Because of the tax structure of investment bonds, withdrawals are deemed as return of capital rather than income, and so do not qualify under the gifts out normal expenditure rule. On the plus side, as long as withdrawals stay within 5 per cent a year of the original sum, the settlor will not be subject to any additional income tax.
Selecting the right trust structure is crucial. Failure to get it right could result in either substantial charges or the money ending up in the wrong hands. The type of structure you choose will be driven by your client’s individual objectives.
There are three to choose from:
Bare (or absolute)
While bare trusts offer the most simplicity, they are also largely inflexible. Once beneficiaries are named at outset, they cannot be changed, and only become entitled to the trust’s assets once the settlor has passed away. For this reason, your client must carefully select those who they wish to benefit.
Any gifts into this type of trust are classed as a potentially exempt transfer. This means as long as the settlor survives seven years from the date of the transfer, no IHT will be payable.
For clients who require more flexibility, one of the other two options are likely to be more suitable.
Under a discretionary trust, distribution of assets is at the discretion of the trustees – no beneficiary has the right to any capital or income. The donor can either name beneficiaries specifically or list a class of people. So, it could be individual names, an organisation such as a charity or sports club, or a specified group such as ‘my children’ or ‘my grandchildren’.
Flexible trusts, also known as interest in possession, are similar to discretionary trusts, but include default beneficiaries as well as discretionary ones. The default beneficiaries are entitled to trust assets unless trustees make further choices. Trustees can name themselves as beneficiaries provided there’s no conflict of interest.
Gifts into both discretionary and flexible are classed as chargeable lifetime transfers, which means any amount over the nil rate band will immediately suffer a 20 per cent IHT charge.
As the name suggests, one of the main attractions with discounted gift trusts is the potential discount. The discount is underwritten, and calculated based on the following factors: life expectancy of the settlor, or settlors if established on a joint basis, together with the size and frequency of withdrawals. In short, younger and healthier settlors will achieve larger discounts.
One thing to bear in mind is that, as the underwriting process is subjective, discounts can differ between providers.
Charges are clearly an important consideration for any financial transaction, and trusts are no exception – though they on apply to discretionary and flexible trusts, not absolute ones. There are two types of charges, one becomes payable on the trust’s tenth anniversary, the other when assets are distributed.
Periodic: on the trust’s tenth anniversary, the value of assets exceeding the nil rate band is subject to a 6 per cent tax charge. For example, if the trust assets total £500,000, with the nil rate band at its current level, trustees will be required to pay £10,500 in tax (£500,000 - £325,000 x 6%).
Exit: if lifetime IHT was paid at the trust’s outset (so, total gifts exceeded the nil rate band), exit fees will apply to any distributions made in the first 10 years. So, by default, if no IHT was payable at the start, exit fees will not apply. After 10 years, exit charges are determined by the settlement rate of tax at the previous 10-year anniversary.
While clearly not suitable for everyone, discounted gift trusts can help your clients reduce their IHT liability while continuing to enjoy an income for life. The key considerations are selecting the right trust structure, and ensuring the client requires no further access to the capital.