A Hargreaves Lansdown survey found that inheritance tax (IHT) is Britain's most hated tax with 1 in 4 people polled putting it at the top of their list. This is despite the fact that less than 5% of estates pay inheritance tax currently.
Inheritance tax is typically paid on estates valued over the IHT nil rate band threshold which is currently £325,000. However, if you're married or in a civial partnership, your partner can inherit any unused allowance after you die. In effect, married couples or those in civil partnership receive a total nil rate band of £650,000. On top of this, if you own a property which is part of your estate, you potentially have a £175,000 residence nil rate band which can also be passed on to your spouse if you die before them. This means, a married couple or those in civil partnership could theoretically pass on an estate worth £1,000,000 without their beneficiaries paying any inheritance tax on it. We discuss this in more detail in our article on "what is the residence nil rate band?".
That said, if you believe your estate could be liable to pay inheritance tax, there are ways to reduce your overall tax bill. Trusts, for example, are one way to reduce your inheritance tax bill. Placing your assets in a trust could mean they're not counted towards your estate for inheritance tax purposes. But, trusts come with their own taxes and charges that can sometimes cancel out the benefits. They're also complex structures that require legal and financial advice to set up correctly. We explore trusts below to help you decide whether they're the right choice for you.
Can you use a trust to reduce your inheritance tax bill?
Putting assets in a trust will reduce your inheritance tax bill as those assets typically won't count towards your estate. But, they are complex structures that come with their own taxes and charges and as such won't be the right choice for everyone. In some circumstances, trusts can work out just as "expensive" as simply paying your inheritance tax bill in the first place. There are, however, circumstances where they can result in a lower tax burden and they have other benefits as well which is why they work well for some.
Setting up a trust can be complex and it's best to get advice to ensure you're doing it correctly. Before you decide to go down this route, it's worth booking a free, no-obligation inheritance tax consultation with a financial adviser*. If you think you will be liable for inheritance tax and want to explore other options to mitigate your tax burden, check out 10 ways to avoid inheritance tax.
What is a trust?
A trust allows you to give up ownership of money and assets for the benefit of someone else.
While tax mitigation is one reason to consider a trust, trusts also have other benefits. For example, they can be a good way to pass wealth on to children or grandchildren by stipulating certain conditions to ensure assets are accessed in a responsible, sustainable manner. There are also trusts designed for vulnerable people, such as those with disabilities, which typically come with lower tax liabilities and can provide for people who may not be able to run their own finances.
Trusts have three main participants - settlors, i.e. those who transfer assets into a trust, trustees - i.e. those who manage the trust, and beneficiaries, i.e. those who benefit from the trust.
Do you pay inheritance tax on a trust?
Assets placed into a trust no longer belong to you as the settlor which means that when you die, they do not count towards your estate for inheritance tax purposes or probate. The assets in the trust won't attract a tax liability when you die. Trusts are therefore sometimes used to reduce your estate for inheritance tax purposes.
That being said, certain types of trusts (notably discretionary trusts) do attract their own inheritance tax obligations when you create the trust and deposit assets. In addition, there are inheritance tax obligations which must be met every 10 years on the anniversary of the trust and when assets are taken out of a trust. Trusts can also trigger a Capital Gains Tax (CGT) liability when you place assets into a trust as this can be treated as a disposal of the asset. Trusts for disabled people have more favourable tax rules if certain conditions are met.
So, to sum up, while the assets in the trust you set up typically won't count towards your estate for inheritance tax purposes, they will often attract their own inheritance tax obligations which can result in a significant tax bill that can erode the inheritance tax savings you were hoping for. In addition, setting up trusts involves various legal and registration costs that can add to the bill.
Not understanding the implications of trust taxation can land you or your intended beneficiaries with a hefty tax charge. This is why it's very important to speak to a financial advisor before you decide to set up a trust. You can book a free, no obligation inheritance tax consultation with a financial advisor* via our website.
Bare trusts vs discretionary trusts
Different types of trusts have different tax implications and are also governed differently.
For example, bare trusts and discretionary trusts are very common types of trusts that are treated very differently for inheritance tax purposes. Below, we outline how they work to help you decide whether they're right for your needs.
Bare trusts
Bare trusts are the simplest types of trusts. Assets are looked after by a trustee on behalf of a named beneficiary (or several named beneficiaries), but the trustee can't decide when or how much income the beneficiary can receive.
Bare trusts are most commonly used to pass wealth onto children. Grandparents, for example, can use them to pass wealth on to grandchildren. Typically, a trustee looks after the trust until the beneficiary (or the child) turns 18 and can then take control of the assets. The trustee's role is primarily administrative.
Funds in the bare trust can sometimes be used before the child turns 18 in some cases, but this must be to benefit the beneficiary - so, for example, to cover school fees where necessary.
Bare trusts do not attract inheritance tax at the outset, unlike other types of trusts.
Your initial transfer within a bare trust is what is known as a potentially exempt transfer (PET) which means that as long as you live for 7 years after you make the transfer, the bare trust will not attract inheritance tax. In this sense, bare trusts work similarly to other types of gifts. As a side note, simply gifting assets outside of a trust can also be an effective way to reduce inheritance tax as we explain in our article on inheritance tax taper relief on gifts.
While bare trusts don't attract inheritance tax like other types of trusts, bare trusts that generate income or capital gains can be liable for income tax and capital gains tax.
However, if the named beneficiaries of the bare trust are children, they have their own personal allowances they can use up before they need to start paying tax on any income or capital gains within the trust.
The exception to this rule is if you're setting up the trust and making deposits as the parent of the child. Under the parental settlement rule, if you set up the trust as the parent of the child, you are liable to pay tax on any income and dividends over £100 per year. The same rule does not apply if you set up the trust as a grandparent, for example. This is why bare trusts are particularly popular with grandparents who wish to provide for their grandchildren.
Inheritance tax could be payable if the beneficiary dies.
Assets in a bare trust are considered to be a part of the beneficiary's estate and as such, if the beneficiary dies with assets in a bare trust, these will be counted towards the beneficiary's estate and could result in an inheritance tax charge if the beneficiary surpasses their own inheritance tax nil rate band.
Discretionary trusts
Discretionary trusts are more complex and give trustees more powers to make decisions about how to use the trust. Depending on how the trust deed is set up, trustees of discretionary trusts can make decisions such as how much to pay out, which beneficiary to pay out money to, and whether to impose certain conditions on the beneficiaries. The role of the trustee here isn't purely administrative as they have a say over who receives income from the trust. This is why it's very important that you appoint trustees you "trust" to follow your wishes.
Beneficiaries of a discretionary trust are often known as "potential beneficiaries" as they are not guaranteed to benefit from the trust. Unlike with a bare trust, the beneficiaries of a discretionary trust are not treated as owning the assets within the trust and therefore the assets would not form part of their estate if they died.
Discretionary trusts have completely different tax implications from bare trusts.
You may need to pay inheritance tax when you transfer assets into a discretionary trust.
A 20% inheritance tax rate on the value of the assets exceeding your nil-rate threshold applies when you deposit the assets into the trust. So, if your nil-late threshold is £325,000 and you put in an asset worth £500,000, you will have to pay an inheritance tax bill worth £35,000.
In addition, if you die within 7 years of transferring assets into a trust, you will need to pay inheritance at the full amount of 40% instead of the reduced 20%. This also applies to any other transfers you may have made in the 7 years before your death after you initially set up the trust.
The trustees will need to pay inheritance tax every 10 years.
This is what is known as the 10-year anniversary charge. This is a type of inheritance tax which is charged at every 10-year anniversary of the trust on assets over the inheritance tax nil rate band available to the trust. A 6% charge applies on the value of the trust above the available nil-rate band which must be settled by the trustees.
Exit charges may apply when assets are taken out of the trust.
If assets (rather than income from the assets) leave the trust and are given to a beneficiary, then an exit charge applies. The exact amount varies depending on several factors and the calculations can be complex. The charge, however, can be up to 6% of the value of the assets.
The above rules pertain to discretionary trusts you set up during your lifetime. The rules are different if a discretionary trust is set up after you die as part of your will.
Summary
Trust can be used to reduce inheritance tax but it is a very complex area of IHT planning and you should seek advice from a financial adviser in the first instance. For more ways to reduce the potential IHT payable when you die read our article on how to avoid inheritance tax.
