Inheritance tax and trusts: how they work

By Street Asset On Jun 20, 2023 0 0

We explain how trusts work and if they can help reduce inheritance tax.

A trust gives you some control and flexibility over who benefits and when. Rather than simply handing over assets such as money or property to an individual, a trust allows those assets to be set aside until a later date.

It can potentially save on inheritance tax (IHT), paid at a rate of 40%, because it will reduce the size of your estate and potentially allow IHT allowances to be retained.

In this guide, we cover:

What is a trust?

A trust is a legal arrangement where you give away assets indirectly. There will be a beneficiary or beneficiaries of the trust, but the trust will be held and managed by someone else – a third party known as the trustee.

A common arrangement is for grandparents to set aside money for grandchildren in a trust, with the parents as trustees. This way, rather than the beneficiaries coming into large sums of cash while they are still young, the money will be held in the trust until they are older and better placed to make informed financial decisions.

Another reason to set up a trust is to help those who may have difficulty managing their own money because they are vulnerable or have a disability.

The two most common types are discretionary and bare trusts.

How do discretionary trusts work?

Discretionary trusts are typically chosen for their flexibility. You do not need to specifically name all of the beneficiaries immediately. So if you are a grandparent, a discretionary trust could also include any unborn future grandchildren.

It is also up to the trustees to decide how the money is allocated.

Pros of a discretionary trust

Flexibility: Adjustments can be made as family members are added or circumstances change
Greater protection: Assets in a trust are separate from the beneficiaries’ personal assets, meaning they can’t be touched in the case of a divorce or other legal dispute
Income flexibility: Income can be taken from the trust or accumulated to benefit from compound growth over time
IHT relief: Putting money in a trust may reduce an inheritance tax bill (see below)

Cons of a discretionary trust

Lack of certainty: Beneficiaries do not have a guaranteed right to assets or money in the trust. Instead, trustees have the power to distribute the assets as they see fit
Complications: Discretionary trusts can be complicated to set up and it is recommended to get legal advice
Ongoing administration: There will be ongoing administration, tax and compliance requirements for the trustees to consider

Bare trusts: the pros and cons

Unlike a discretionary trust, with a bare trust – often used to pass on assets to young people – the beneficiary has a fixed entitlement to assets. They can take out money from the trust from the age of 18 (16 in Scotland), although the trustees can withdraw money before then for the benefit of the beneficiary – for example, a parent might take out money from the trust to pay for school fees.

Pros of a bare trust

Convenience: Easier to set up than a discretionary trust. You can open a bare trust in minutes with small sums of money
IHT relief: money and assets placed in a bare trust should be free of inheritance tax as long as the person making the bequest lives for seven years after making the transfer into the trust.
Tax efficiency: Income is taxed at the child’s marginal rate, meaning it is likely to be tax-free
Earlier access: The funds can be accessed before a child turns 18. This means bare trusts are sometimes used instead of a junior ISA, because there is more flexibility of when the fund can be accessed

Cons of a bare trust

Beneficiary has full rights: The beneficiary has total control over the assets in the trust from age 18, so a bare trust may not be appropriate for those who are vulnerable or may have difficulty managing their own money
Limited asset protection: Because the beneficiary is named on the trust, the assets could be accessed for potential bankruptcy or debt obligations
Simplicity: They are easier to set up than discretionary trusts and may not be appropriate for more complex situations

Inheritance tax and trusts: how they can reduce your IHT bill

When you put money and assets into a trust, you are giving up your right to them. This means they have left your estate and the value may not be counted for IHT purposes if you die at least seven years after they are transferred into the trust.

Not…