How do trusts work?

If you are one of millions of people whose estate could be valued above the inheritance tax nil rate bands when you die, trusts offer a way to protect your legacy for your kids and grandkids.

Having paid tax on their income all of their life, many people find the idea of the money that’s left when they die being taxed again as a bitter pill to swallow. Historically inheritance tax was seen as only for the very wealthy, but rising property prices and frozen thresholds are changing that.

The IHT nil rate band, which is the threshold at which inheritance tax becomes payable by your beneficiaries after you die, has been fixed at £325,000 since the 2009/10 tax year. Had it risen in line with inflation it would currently be about £485,000. The threshold freeze has meant more people than ever are approaching retirement having to think about how to protect their legacy.

The easiest way to pass on assets you own valued over £325,000 without triggering any tax charge is by gifting them at least seven years before you die. However, this is highly impractical if you wish to maintain some access and control over your assets while you are still living, as most people do. If your most valued asset, meanwhile, is your home, your nil rate band can be extended to £500,000, but your children will still have to pay inheritance tax if you gift it to them and wish to continue living in it until you die (unless you pay them rent at current market value), and the additional band of £175,000 will be restricted if your estate exceeds £2 million

It is this conundrum which makes trusts such a popular vehicle for reducing the value of your estate for inheritance tax purposes while also maintaining some control over your assets. When you transfer assets into a trust, you no longer own them which means they won’t be valued as part of your estate when you die, if you survive for 7 years after the gift to the trust. However, you can stipulate terms to ensure your legacy is treated as per your wishes and keep control over how and when your assets can be accessed.

“There are lots of different reasons you might want to consider a trust,” says Gill Philpott, Tax and Trust Specialist at Ascot Lloyd. “If your children are already wealthy, rather than passing your money to them you might want to set up a trust to benefit your grandchildren and great grandchildren, helping them onto the property ladder, paying for education or paying off mortgages. If you have a vulnerable family member who you worry might not be able to provide for themselves, a trust is a useful tool. It provides generational benefits and an enduring legacy.”

Managing your legacy

There are many kinds of trusts which serve different purposes. This article focuses on more formal trusts rather than bare trusts, which is the simplest form of trust most typically evident in bank accounts which you don't wish your children or grandchildren to access until they are 18.

In the last couple of years, regulation for the trusts typically used for IHT planning has increased through the HMRC's Trust Registration Service (TRS), which provides a single online route for trusts to comply with their registration obligations. Previously only trusts which had incurred a tax liability were required to notify HMRC of their existence, but since 2021 all trusts now need to register with TRS. While that means there's extra admin to think about, trusts remain a great way to manage your legacy.

Essentially, a trust is a legal arrangement with three parties. The settlor is the person making the gift (putting the money into the trust). The trustees are the people who will be responsible for looking after that money (including investing it and making decisions about payments out of the trust). You can be both a settlor and a trustee (while you are still alive). Finally, there are the beneficiaries, who can be named or unnamed and can have different classes entitling them to different rights. When you first gift money into the trust you don’t have to immediately decide who gets what. Indeed, part of the appeal of trusts is their flexibility when it comes to providing benefit for immediate family and future generations.

“There are a number of crucial things you need to think about with trusts,” says Philpott. “How much can you afford to give away and maintain your lifestyle? Will you want to withdraw a regular income from the trust? That will determine the sort of trust that might be suitable. Think very carefully, about who your fellow trustees will be. They'll have responsibilities. But also think broadly about the beneficiaries. Are there other parties you want to include, like a charity? Do you want to name who your beneficiaries are, or even restrict it to a certain pool of people?”

Taxing trusts

When you make a gift to a trust, it's called a chargeable lifetime transfer. If the gift is lower than your IHT nil rate band, the charge is 0%. Above it, the charge is 20% (half of the IHT rate), payable at the time of gift. Your nil rate band resets after seven years, so you could set up a succession of trusts every seven years and each time gift up to £325,000 without paying tax.

There are different trusts to suit different objectives. For example, if you need an income to supplement your retirement, a discounted gift trust allows you to maintain a right to some of the money you put in. The remaining balance when you die is left for your beneficiaries. By retaining that right, the value of the gift is deemed to be less than the amount you put in, which means you can put in more without paying tax.

Loan trusts also give you the option to take ‘income’ but by means of regular loan repayments from the trust. The settlor makes an interest-free loan to the trustees through the trust, which is repayable on death or on demand. This has the effect of freezing the value of assets and allowing growth, through investment of the loaned monies, to accumulate outside of your estate. As the proceeds are held in an investment bond, regular withdrawals from the bond of up to 5% of the value invested can be taken with tax deferred for 20 years (or until the bond is cashed in).

These are just a couple of examples, there are other opportunities to plan with trusts, your Ascot Lloyd financial adviser can help you to understand the choices available to meet your objectives.

Every 10 years

Although money up to your nil rate bands can go into a trust tax free, it’s important to understand how trusts themselves are then treated by HMRC. For typical discretionary trusts and lifetime trusts, every 10 years a 6% tax charge is payable on the value in the trust above the current nil rate band. So although there might be some tax to pay every decade and forms to fill in, the actual tax cost is low compared to the 40% inheritance tax that would be payable. If assets are removed from the trust then IHT may need to be paid on the exit, but you only pay the exit charge for the period between the last 10-year charge and when the money is taken out.

Trusts are also subject to varying rules on paying income tax and capital gains tax within the trust, however through careful planning by the trustees there are ways to manage this. As just one example, if a trust holds a general investment account, if you pay some of the income generated out to non-taxpayer beneficiaries, for example to grandchildren to pay for their school fees, they can then reclaim all of the income tax which has been paid by the trustees. If the trust holds a bond, again with planning income tax can be managed.

“If the trustees are having meetings each year to manage the trust, which is one of their responsibilities, then they can think about these sorts of planning points and manage the income tax and capital gains tax consequences as they go,” says Philpott. “There's undoubtedly some complexity so it is advisable to have a professional there to help you make those decisions. A trusted independent financial adviser can also provide invaluable advice from the outset in determining which trust structure will be the best for your objectives.”

If you think your estate will be valued above your nil rate band and believe a trust could be a good way to protect your legacy, book a call back with an Ascot Lloyd financial adviser.