Can setting up a trust help reduce your inheritance tax bill?
- TBA
- Aug 7, 2024
- 4 min read
When it comes to inheritance tax, setting up a trust is often viewed as an effective way to reduce taxes. By placing your savings, property, or other assets into a trust, these assets technically no longer belong to you—meaning they might not be included in your estate when calculating inheritance tax upon your death.
However, the relationship between inheritance tax and trusts is quite complex. Transferring assets through a trust to your relatives does not necessarily completely exempt them from taxes.
Different types of trusts have different tax rules. Therefore, it’s essential to thoroughly understand the relationship between trusts and taxes before making any decisions.
1. What is a trust?
A trust is a financial arrangement and a special form of property management that has been used by many families for centuries. You can transfer cash, property, or any investments to a trust, empowering trustees to manage these assets for the benefit of the beneficiaries, who will eventually receive the assets or income from them.
In any trust, there are three roles:
Settlor – The original owner of the assets.
Trustee – The person or institution managing the trust assets, with powers similar to owning, buying, selling, and investing these assets. Trustees are responsible for operating the trust and managing its assets.
Beneficiary – The person or entity for whom the trust is set up, ultimately enjoying the benefits of the trust.
For example, you (the settlor) can set up a trust and arrange for your children (trustees) to manage it, paying for your grandchildren’s (beneficiaries) university education or covering lifetime living expenses for a disabled family member (beneficiary) until they reach a certain age. All these arrangements would be outlined in the trust deed.
2. How is inheritance tax applied to trusts?
Under current UK legislation, when a person dies, their heirs must pay inheritance tax on their estate—currently at a rate of 40% of the estate’s value. If you set up a trust, the value of cash, investments, or property within the trust is usually not included when calculating inheritance tax upon the settlor’s death.
However, trusts are not entirely tax-free and have their own set of tax rules. If the assets placed into the trust exceed the nil-rate band, typically 20% inheritance tax is payable upon setting up the trust.
Additionally, further taxes are applied at different intervals. While trusts can help reduce tax liabilities to some extent, it’s crucial to consult a professional to understand the specific tax implications of different types of trusts.
Here’s a common example of using a discretionary trust for inheritance tax planning:
Pay 20% Inheritance Tax when setting up the trust
Calculate the value of assets exceeding the inheritance tax nil-rate band and pay 20% tax on that amount.
The 20% charge applies to the value of the assets placed into the trust, minus any unused nil-rate band from the past seven years. For instance, if you place £400,000 worth of assets into a trust and have not used any of your £325,000 nil-rate band elsewhere, you will pay £15,000 (20% of the £75,000 exceeding the nil-rate band). If multiple trusts are set up within seven years, the nil-rate band is split accordingly.
Pay 6% Inheritance Tax every 10 years
Every 10 years, the assets in the trust are revalued, and a 6% inheritance tax is applied to their value, after deducting the nil-rate band.
For example, if the value of a £400,000 investment increases to £500,000 over 10 years, £175,000 would be subject to 6% tax, resulting in a £10,500 tax charge.
Pay up to 6% exit charge
When the trust is terminated or assets are transferred out, an exit charge of up to 6% is applied, proportionate to the number of years since the last 10-year charge.
For instance, if Sally places her £500,000 property into a discretionary trust, and over 10 years its value rises to £750,000, an exit charge would be calculated on £425,000 at 6%, resulting in a £25,500 tax charge.
3. Types of trusts
Several types of trusts can assist with inheritance and tax planning. We will cover a few common ones, but please note that other arrangements can also be set up using a will. We suggest that you consult a relevant professional for further advice.
Bare Trusts
Bare trusts are simple and used to hold assets for others until they choose to take ownership. For instance, parents might use bare trusts to hold assets for their children to ensure they do not use them prematurely. Assets in bare trusts are treated as potentially exempt transfers, meaning no tax is payable when the trust is set up, but if the settlor dies within seven years, the trust’s assets become part of the estate and may be taxed.
Discretionary Trusts
This flexible trust type allows trustees to decide how to distribute income and capital to beneficiaries. Because the trust fund is independent, it is not included in the estate. For example, parents may use discretionary trusts to provide for children and future descendants for education, health, or purchasing property.
Loan Trusts
With a loan trust, you lend your assets to a trust, meaning the assets remain part of your estate. However, any investment gains remain in the trust and are not part of your estate, reducing tax liability on those gains.
Discounted Gift Trusts
These trusts typically hold insurance bonds, providing up to 5% income annually. The capital is not part of your estate and transfers to beneficiaries upon death.
A word from TB Accountants
Trusts offer a way to manage your estate, allowing you to control the distribution and use of your assets while potentially reducing tax liabilities. However, the relationship between inheritance tax and trusts is complex, and in special cases, setting up a trust may result in higher tax payments. TB Accountants recommend consulting a knowledgeable accountant for professional advice if you intend to use a trust to manage your inheritance tax bill.