Using trusts to avoid inheritance tax
Trusts are an often overlooked way to manage your estate when you pass away, keeping an element of control over what happens to your assets and how they can be used.
The tax treatment of trusts can also mean they're useful for reducing the amount of inheritance tax that will be paid. However, the rules around inheritance tax and trusts are complicated, and it may cost you more.
As such, you should think carefully before setting up a trust to avoid inheritance tax. They can be expensive, and tax shouldn't be the main reason for setting one up.
- Need help with probate? Download our free checklist from Which? Legal Probate to help you through the process.
How do trusts work?
As the creator, or 'settlor', of the trust, you stipulate how it ought to be run. After you pass away, the ownership and control will shift to your nominated trustees, who are legally obliged to manage the assets on behalf of your beneficiaries.
You'll agree a trust deed, which dictates how the trustees should do that. You must have confidence in the trustees, as they'll legally own the assets. Note that settlors can be trustees too.
Assets in trust don't form part of your estate, meaning they won't be included when working out how much inheritance tax is due, providing you live for seven years after placing them into trust.
They come in many forms, and there can be variations in the rules, depending on the type of trust it is.
How are trusts taxed?
It's a common misconception that assets in trust are exempt from inheritance tax. You'll normally pay it at 20% when setting up a trust. There are some exceptions, such as if you continue to benefit from the assets.
The way a trust is taxed depends on what sort of trust it is.
For a discretionary trust (the most commonly used for inheritance tax planning), the rules are as follows:
How do the tax charges work?
The 20% charge applies to the value of assets you put in the trust, less any inheritance tax allowance you haven't used in the last seven years. So, if you placed assets worth £400,000 into trust and hadn't used your allowance elsewhere, you would pay £15,000 (20% of the £75,000 in excess of the £325,000 allowance).
If you set up multiple trusts, this will be factored in when you pay tax establishing the trust. So if the second trust is established within seven years of the first, you can't claim the £325,000 allowance - only any amount you hadn't already used.
On top of the tax paid when setting up the trust, there's also a tax charge on assets in trust every 10 years afterwards. This is levied on the current value of the assets, after deducting the £325,000 inheritance tax allowance. So if that £400,000 investment increased in value to £500,000, IHT would be due on £175,000. This is charged at 6% (over the £325,000), so in this example there would be a £10,500 bill.
Finally, an exit charge is levied if or when assets are removed from the trust, or the trust is closed. The tax is charged at the most recent 10-year valuation. Again, the £325,000 IHT allowance is deducted, so if the estate is worth £500,000, then £175,000 would be subject to IHT.
The same 6% applies, though it is charged on a pro-rata basis, since the last 10-year charge. So if five years have passed, you'll pay 3%, and if only one year has passed then 0.6% is charged.
Example: tax on discretionary trusts
Say Carla is transferring her £500,000 property into a trust.
She hasn't used any of her £325,000 personal allowance in the last seven years. So £175,000 of her property's value is subject to 20% tax on setting up the trust, resulting in a £35,000 bill in the first year.
The assets are re-valued every decade. The property value increases to £750,000 in the first ten years - this is subject to a 6% tax, less than £325,000 allowance. So the tax bill would be 6% of £575,000, for a total of £34,500 after 10 years.
Five years later, the trust is closed. In that time, the property value has risen to £800,000 - minus the allowance, it comes to £475,000. It's only been five years, so the 10-year tax rate of 6% is halved to 3%.
This means 3% tax is payable on £475,000, for a total of £14,250 as an exit charge.
- Find out more: How much inheritance tax will I pay?
How are bare trusts taxed?
Bare trusts are used to leave assets to children to ensure they don't use them until they're grown up. These types of trusts don't follow these inheritance tax rules.
Instead, assets placed in a bare trust are treated as potentially exempt transfers.
You'll pay no IHT when establishing the trust, but if you die within seven years of creating it, it will be taxed as part of your estate.
To find out more about potentially exempt transfers, read our guide on inheritance tax on gifts.
What sort of trusts can be set up?
There are many options available to people setting up trusts, and this list is not comprehensive.
This list covers trusts you set up before passing away, though other arrangements exist to establish trusts in your will.
These simple trusts are for child beneficiaries. All assets in the trust will transfer to the beneficiary when they turn 18 (16 in Scotland). For tax purposes, these are treated as gifts, so provided you live for seven years there will be no IHT to pay.
Discretionary gift trusts
The most popular type of trust. You hand over the assets to the trust and stipulate how you would like them to be used for the beneficiaries. Crucially, the trustees are free to act at their own discretion. The new property IHT allowance can't be claimed against property in a discretionary trust, so if you're already set up one you should review your arrangements with an adviser.
Available 'over the counter', these can be used to limit future gains in the value of your estate. You lend your assets to the trust, meaning they still form part of your estate. However, any investment returns from your assets remain in the trust, and fall outside your estate for tax purposes.
Discounted gift trusts
These are typically used to hold insurance bonds and allow you to receive income for up to 5% of the bond each year. The capital sits outside your estate and transfers to the beneficiaries when you die.
- Find out more: will trusts and lifetime trusts
Where can I get advice on trusts?
You'll want to seek the advice of a lawyer or accountant with knowledge in this area.
STEP (Formerly known as the Society of Trust and Estate Practioners) manages a database of people who can help with this. Visit its website for more information.
What will a trust cost?
It really depends on your circumstances.
In addition to the inheritance tax charge when setting up the trust, the trustees will likely charge a fee to manage the trust, and there are other legal costs to setting one up.
Due to these expenses, you should carefully weigh up whether your estate would benefit from a trust.
Find out more: inheritance tax rates and allowances