Knowing how and what to leave behind when you die is emotionally challenging, not to mention financially. Depending on the size of your estate, the UK’s tax authority, HMRC, may claim a sizeable portion of your assets as Inheritance Tax (IHT) before they are passed on to your loved ones.
To avoid this scenario, some people prefer to place their assets in a ‘trust’, the likes of which can either be tax-exempt or more tax efficient. Knowing how trusts and inheritance tax work is key to minimising the taxation of your estate when you die.
The laws surrounding trust inheritance tax are complex, however, and if mismanaged may ultimately cost you more than were you not to set up a trust in the first place. We highly recommend seeking the assistance of a tax professional before tackling your inheritance tax concerns or opening a trust.
This article will explore:
Contents
- Trusts and Inheritance Tax: How Trusts Affect Your Assets
- What is a trust?
- How trusts and inheritance tax work: Reducing IHT with a trust
- Setting up an inheritance trust fund
- Minimise trust inheritance tax with professional guidance
What is a trust?
A ‘trust’ is a legal arrangement between three parties: the settlor, the trustee or trustees, and the beneficiary or beneficiaries. It is a way for someone (the settlor) to indirectly give away their assets to another (the beneficiary) via an intermediary who is put in charge of the assets and transfer (the trustee).
In legal terms, once assets are transferred to a trust, they are no longer the property of the settlor but belong instead to the trustee(s) charged with delivering them to the beneficiaries. It is for this reason that trusts and inheritance tax go hand-in-hand—because assets are no longer the legal property of the settlor, they are not considered to be a taxable part of the settlor’s estate upon their death (provided the settlor lives for a minimum of 7 years after establishing the trust).
It is important to note, nonetheless, that trusts carry their own tax rules and so are not, in and of themselves, a means to give away money for free.
There are a number of different types of trust you can open:
- Base trust: The simplest and most common form of trust, in which beneficiaries gain access to all assets at the ages of eighteen (England, Northern Ireland, Wales) and sixteen (Scotland).
- Discretionary trust: The second most common type of trust, in which the trustee(s) have total control over the trust’s assets (e.g., making investment decisions for the trust) and how the assets are distributed to its beneficiaries.
- Interest in possession trust: This is a trust designed to provide income to your chosen beneficiaries, without allowing them access to the assets which generate that income.
- Mixed trust: A mixed trust is exactly what it sounds like—a trust combining elements of other standard trust models for the purposes of meeting a settlor’s specific wishes.
- Trust for a vulnerable person: Trusts set up with a single vulnerable person or multiple vulnerable people (i.e., children, disabled people, etc.) are subject to special tax treatment and allowances.
- Non-resident trust: Trusts set up for beneficiaries living outside of the United Kingdom may also receive tax benefits like paying no inheritance tax at all, or a reduced income tax on income withdrawn from the trust.
One of the main benefits of opening a trust is that the settlor has greater control over how and when their assets are inherited or gifted.
For example, a settlor may open a trust with their grandchildren as the beneficiaries and their children (i.e., the grandkids’ parents) as trustees. They could then stipulate that the assets in the trust are not to be inherited by the grandchildren until they reach a certain age and are therefore more able to make informed financial decisions.
What kinds of assets can be put into a trust?
When a trust is created, the settlor writes a ‘trust deed’. This deed establishes:
- What assets are going into the trust
- Who the trustees are
- How the trustees are to manage the trust’s assets
- Who the beneficiaries are
- When and how the beneficiaries are to receive the assets in the trust
Settlors can transfer various types of assets into a trust, including cash, property, shares and land. It is common, for example, for settlors to reduce their estate to a less-taxable value by placing their family home and/or lands into a trust.
Reducing inheritance tax with a trust
It is possible to use trusts to reduce the tax your chosen beneficiaries will have to pay when you die. The most common means of doing so is to place enough assets into a trust to lower the value of your estate below the inheritance tax personal allowance of £325,000.
For example, if you had cash and shares worth £320,000 and real estate worth £500,000, you could place the real estate in a trust. In doing so, you would no longer legally own the real estate, meaning it should not be hit by inheritance tax when you die. At the same time, neither would your personal estate be inheritance-taxed, because it would now be valued below your tax-free allowance.
However, trusts are not a foolproof way to avoid paying inheritance tax. Whilst they can be used to minimise future IHT bills, and to maximise the tax efficiency of any asset transfers upon your death, trusts do still carry their own unique tax laws.
For example, Capital Gains Tax may still apply to properties sold to a trust or a property inherited from one. As such, it’s important to know how trust inheritance tax works if you wish to make your money stretch as far as possible.
Who should consider setting up a trust?
On average, just 4% of deaths in the UK trigger an inheritance tax charge. This is because a person’s estate must exceed the IHT personal allowance of £325,000 before the tax applies.
Your personal tax-free allowance increases to £500k if you’re leaving your main home to your children or grandchildren, and doubles (i.e., to £650k or £1m) if you are married or in a civil partnership.
Moreover, it can be costly to establish a trust.
For the reasons presented above, only those with large estates exceeding the inheritance tax personal allowance by a significant amount should consider setting up a trust for tax purposes.
You could of course choose to establish a trust for other, non inheritance-tax related reasons, however, like controlling and protecting your family assets.
How trusts and inheritance tax work: Reducing IHT with a trust
We’ve touched before on one of the ways trusts can be used to reduce inheritance tax—by moving a portion of assets out of one’s possession, thus lowering the value of an estate below the inheritance tax personal allowance of £325,000-£1,000,000, depending.
There are other ways, too, by which trusts can make your estate more tax efficient, to the benefit of loved ones left behind in the event of your death.
In this section, we take a look at how trusts and inheritance tax work, as well as how tax on trusts is calculated in each scenario.
Inheritance tax example: Bare trusts
Bare trusts are most exempt from inheritance tax, and as such may be your best bet in terms of reducing your inheritance tax bill.
Provided you carry on living for a minimum of seven years after the date the trust is established, then you pay 0% tax on the assets transferred into the trust, and your beneficiaries also pay 0% tax on the assets released from it.
The downside to bare trusts is their simplicity. Because the beneficiaries are named on the trust and have full control over the assets once they reach the age of 16-18 (depending on location), this trust structure may not be well-suited to vulnerable beneficiaries.
Inheritance tax example: Trusts for vulnerable persons
Similar to bare trusts, any trust established for a vulnerable person or persons should also be wholly exempt from inheritance tax.
Inheritance tax example: Interest in possession trusts
The laws surrounding interest-in-possession trusts have changed.
For any assets transferred into this type of trust before 22 March 2006, there is no inheritance tax to be paid on the trust or its assets. However, since 5th October 2008, inheritance tax rules do apply to interest-in-possession trusts.
Should any post-2008 ‘interests’ be transferred to a new beneficiary, there will be a 20% IHT incurred, and the trust may then be subject to a rolling 100-year-anniversary charge of 6% pro rata on the trust as well.
Inheritance tax example: Discretionary trusts
As the most common tax-efficient inheritance trust model, discretionary trusts are subject to inheritance tax. Inheritance tax on discretionary trusts can get quite complex, so seeking the assistance of a personal accountant is advisable. Below are the various circumstances under which inheritance tax is applied to discretionary trusts and their assets.
1) 20% inheritance tax at setup
You get a personal tax-free allowance from inheritance tax, typically of £325,000 if you haven’t already used some of this allowance. When transferring assets to a discretionary trust, you will be charged 20% IHT on the value of those assets exceeding your remaining personal allowance.
2) 6% inheritance tax every ten years
Your discretionary fund will also be inheritance-taxed pro rata at every 10-year anniversary from the date the trust is established. A 6% IHT is applied to the value of the trust’s assets once again exceeding the inheritance tax allowance. This value may have increased over time, especially if you have transferred appreciating assets like property or shares.
3) Up to 6% inheritance tax when assets are removed or the trust closed
Finally, IHT is charged one last time when the beneficiaries receive their assets and/or the trust is closed. The IHT rate charged depends on how long it’s been since the last 10-year anniversary valuation. For example, if it’s only been five years, then the pro rata 6% becomes 3% instead. If it’s been just one year, the IHT rate is 0.6%, and so on.
Setting up an inheritance trust fund
Setting up an inheritance trust fund can be fairly straightforward or challengingly complex, depending on the value and nature of your assets, as well as the type of trust you wish to open.
Bare trusts are often offered by investment platforms, meaning that there are a lot of different options on offer which can be set up quickly and easily.
Discretionary trusts, on the other hand, are much more complex and will require the assistance of both a tax expert and the expertise of a solicitor.
Minimise trust inheritance tax with professional guidance
After working hard all your life to build up a sizeable estate, the last thing any of us wants is to see a large chunk of our savings lost to HMRC’s inheritance tax pot. But becoming inheritance tax efficient can be quite challenging.
Establishing a trust can help you to lower the tax amount your loved ones will have to pay when you die—both through favourable tax terms attached to the trust, and by lowering the taxable value of your estate by giving up ownership of certain assets.
However, not every trust is inheritance-tax-free. Whilst bare trusts may preclude you and your beneficiaries from inheritance tax, other trusts like discretionary trusts incur regular IHT charges.
To make the most out of your money, and ensure your loved ones receive their full inheritance, talk to a tax advisor today.
