When estate planning, it is important to be aware of the most tax efficient ways of protecting your assets. For many families, inheritance tax can be costly and stressful as you think about the next generation. With shrewd and strategic planning, there are ways in which you can mitigate its impact. In this guide, we consider whether trusts are an effective vehicle for reducing tax exposure and how they can be used to your advantage.
Trusts
In the UK, trusts are frequently used in estate planning, but their value in helping you avoid inheritance tax (IHT) invariably depends on the type of trust, its structure and the way it is used. It is vital that you understand how they are affected by HMRC rules, what tax advantages are conferred, and how they can be managed effectively.
Before undertaking estate planning, it can be good to be aware of what a trust is and why you might create one. A trust is typically defined as a legal agreement under which a settlor authorises trustees to oversee selected assets for the eventual benefit of nominated beneficiaries.
UK-based trusts function by distinguishing legal and beneficial ownership. Trusts often play a significant role in inheritance tax planning. They are most commonly used to protect assets from care costs and divorce settlements, control the amount and timing of an inheritance, and to reduce IHT liability.
As of 2024, the residence nil-rate band stands at £175,000. This can raise the overall IHT-free allowance to £500,000 for individuals or anywhere up to £1 million for couples in situations where both allowances are fully utilised. Since not all trusts enjoy the same IHT status, it is vital you are aware of the different options.
Bare Trusts
In England, a bare trust, also known as a simple trust, names the designated beneficiary outright, giving them full access to bequeathed assets upon turning 18. Because they are incorporated into the beneficiary’s estate, these are not a good method for avoiding IHT.
Discretionary Trusts
Discretionary trusts authorise trustees to determine how assets should be distributed amongst beneficiaries. Whilst they can’t help you avoid inheritance tax, they do remove assets from the settlor’s estate, provided they live for another seven years following the transfer of the gift.
Interest in Possession Trusts
These enable a named beneficiary to take advantage of trust income during their lifetime. These trusts are usually included in the beneficiary’s estate for IHT reasons, so there is limited scope for inheritance tax mitigation.
Trusts for Vulnerable Beneficiaries
You might also wish to consider the special rules for trusts for people with learning difficulties or disabilities. These might benefit from IHT exemptions and more favourable income tax regimes.
Nil Rate Band Trust Planning
Couples can create trusts that maximise the nil-rate band after the first spouse dies. This maintains that allowance and reduces the second estate’s tax bill.
Trusts with Life Insurance Policies
If you put a life insurance policy in trust, that means you can ensure the payout isn’t part of any taxable estate. As a results, this effectively avoids IHT on that amount. This is considered one of the most effective methods of legally avoiding inheritance tax via a trust.
There are some exceptional instances in which a trust could avoid IHT but generally they are more likely to reduce of delay the amount paid. Under the provisions of the ‘Seven Year Rule’, assets placed in a discretionary trust might be classified as a ‘potentially exempt transfer’ (PET).
Tax rules to consider
Whilst trusts reduce IHT, there are still tax responsibilities to think about. The initial charge is 20% for transfers into those discretionary trusts sitting above the nil-rate band. There is a periodic charge every 10 years which is up to 6% on those trust assets beyond the nil-rate band. There is also an exit charge levied when assets are withdrawn from the trust. Such taxes will be applied depending on the nature, size and time of the trust.
Setting up an IHT-efficient trust
Before setting the wheels in motion, you should be sure of your goals, ensuring that you are fully aware of tax rules and regulations. This is why it is so important to work with a reputable financial planner who can offer guidance and strategic paths forward.
To find out more about estate and trust planning in Cheshire and Oswestry, you can get in touch with the team at Hartey Wealth Management today to set up an appointment.
