Introduction
The fundamentals of inheritance tax (IHT) have been covered along with simple estate reduction strategies. Now, the focus shifts to advanced planning with discretionary trusts, not just for the ultra-wealthy, but for anyone seeking control, protection, and IHT efficiency when passing on wealth.
What is a Discretionary Trust?
A legal structure in which a settlor (the person establishing the trust) appoints trustees to hold and manage assets, such as money, property, or investments, on behalf of a group of beneficiaries, often family members. The trustees have discretion over when, how much, and to whom distributions are made, which may be guided by criteria like age milestones or educational achievements. Importantly, beneficiaries do not have an automatic entitlement to the assets held within the trust.
Assets such as watches, cars, jewellery, art, and other investments can be transferred into trust, provided they are valued at market rate and properly documented. Although investment properties are suitable, a main residence is usually unsuitable, as placing it in a trust may remove main residence capital gains tax (CGT) relief and may trigger stamp duty land tax (SDLT) on market value.
The focus for this part will be on discretionary trusts, as they are the most relevant to IHT.
When Should a Trust Be Considered?
The decision to set up a discretionary trust should align with personal goals, not just net worth. A trust may be appropriate if any of the following apply:
- Control: To avoid gifting lump sums outright to younger children or financially inexperienced family members.
- Protection: To safeguard against divorce, poor money habits, or external claims on family wealth.
- Tax Efficiency: To remove assets and future growth from the estate and reduce the IHT burden.
General Rule of Thumb: Trusts become effective for estate planning when there are £325,000+ in assets that are no longer needed for personal lifestyle. Even from £200,000, a discretionary trust can be beneficial in the right circumstances.
Main Drawbacks
- Discretionary trusts can be complex and require ongoing administration fees.
- Entry charges, a periodic 10-year charge, and exit charges may apply.
- Loss of personal access and income from the transferred assets.
- Trusts face higher tax rates: the first £500 is tax-free, with anything above taxed at up to 45% (non-dividend) and 39.35% (dividends). Beneficiaries may reclaim some or all tax paid depending on their marginal rate.
- CGT exemption for trusts is £1,500 annually (2025/26 rate), with gains above that taxed at 24% including for residential property. This applies to disposal of assets, not entry.
Trusts are typically used for non-tax reasons such as asset protection, IHT planning, and retaining control. Ideally, income and gains are retained or distributed to beneficiaries in lower tax bands to minimise exposure.
Entry Charge
A tax rate of 20% applies to assets or cash placed in a trust above the £325,000 nil rate band. This is an immediate charge, known as a chargeable lifetime transfer. If the donor dies within seven years, taper relief may reduce the tax. After seven years, the nil rate band resets, allowing further transfers of up to £325,000 per person, or £650,000 for a couple.
Why Gift Cash to a Trust If It’s IHT-Free After 7 Years Anyway?
While gifting cash directly may be IHT-free after seven years, it means losing control over how the money is used and exposes it to risks like divorce, debt, or poor financial decisions.
10-Year Charge
The 10-year charge is a tax rate of up to 6%, on the value of the trust’s assets (above the nil rate band) at the 10-year anniversary of creation, and every 10 years afterwards until the trusts expiry date of 125 years.
Exit Charges
There is no exit charge if the trust’s value is below the nil rate band and no tax was due at the last periodic charge. Exit charges apply when capital is distributed from the trust to beneficiaries. Trustees must report and pay the charge to HMRC within six months of exit, using records from the last 10-year charge.
Why Are Trusts Still Popular Despite the Charges?
- Control: The ability to dictate how and when assets are distributed, even after death.
- Nil Rate Band: Utilisation of the nil rate band in lifetime and on death (if the donor survives seven years) offers further incentives. With careful asset profiling, exposure can be significantly mitigated.
Tax Rates:
- Entry tax applies only to assets over £325,000.
- CGT isn’t due on entry if holdover relief is claimed; tax is deferred until trustees sell the asset. This is particularly useful for clients with investment properties.
- SDLT may apply if the trust takes on debt, but not if the transfer is a genuine gift with no consideration.
Can a Pension Be Put into a Discretionary Trust?
No, pensions cannot be transferred into a trust during one’s lifetime, as they are controlled by the scheme provider. However, a trust can be nominated to receive the lump sum death benefit, similar to naming individual beneficiaries.
Example
Dr. Yakub and his wife own three investment properties intended for their adult children. Gifting them directly would trigger immediate CGT, payable within six months. Concerned about his youngest child’s age and the recent marriages of the others, Dr. Yakub instead transfers £600,000 of property into a discretionary trust, using both his and his wife’s nil-rate bands (£650,000).
With no debt involved, there is no SDLT, and CGT is deferred until the properties are sold. No entry charge applies as the value is within the nil-rate band. The trust deed specifies that the two eldest children inherit their properties when buying their first homes, and the youngest upon completing university.
This approach reduces IHT exposure after seven years, protects the assets, and ensures the wealth supports his family’s future. Note: Minors cannot legally own property in the UK, so a trust must hold it until they turn 18.
Coming up in Part 4
Trusts are one tool in advanced IHT planning. In Part 4, we will explore the Family Investment Company (FIC), compare it with trusts, and examine scenarios where combining both may offer the most effective results.
