When it comes to planning your financial future – in particular, the legacy you’d like to leave your heirs – an understanding of how Inheritance Tax (IHT) works is essential.
IHT can have a real impact on the value of your assets when you die and, if you don’t manage your affairs carefully, your family could face an unexpected and unwelcome tax bill.
Read about how IHT is calculated, and how you can use trusts to potentially reduce your IHT liability, or even eliminate it totally.
How IHT is charged on the value of your estate
IHT is payable by your estate at 40% on the value of your estate above the nil-rate band (NRB).
The current NRB (2021/22) is £325,000. On top of that, each person has a residence nil-rate band (RNRB), which is £175,000 in the 2021/22 tax year. This applies if you intend to leave your home to children or grandchildren.
If you’re non-UK domiciled, this applies to your UK estate only, but if you’re UK-domiciled it applies to your worldwide estate. We published a guide recently that explains this in more detail.
There are several financial steps you can take to help reduce, or even totally eliminate, the amount of IHT your family has to pay to HMRC when you die.
One common method is using trusts.
How trusts work
In simple terms, a trust is a legal agreement that moves money out of your direct ownership with the ultimate aim of it passing to someone else, usually when you die. Once your assets are in a trust, you no longer have full control of them, and they are managed by the trustees under the terms of the trust deed.
Sometimes you’ll hear the expression “discretionary trust”. All this means is that assets are in trust, but the beneficiary has not immediately been decided on. The settlor (the person transferring assets into the trust) can outline to the trustees how they would like benefits to be distributed by completing a ‘letter of wishes’, however the trustees ultimately have ‘discretion’ over how, when and who to pay benefits to from defined classes of beneficiaries.
Alternatively, some types of trust are referred to as ‘absolute’. Under these types of trusts, the beneficiaries nominated at outset cannot be changed and they will become absolutely entitled to their share of the trust assets upon a certain event happening (usually the death of the settlor).
The wording and setting up of some trusts can be complicated, but ultimately that simple description applies to most trusts.
Here are details of three different trusts, all of which can be used to help reduce an individual’s IHT liability.
Potentially reduce your IHT liability with a nil-rate band trust
The maximum you can settle into a discretionary nil-rate band trust over any seven-year period without incurring a 20% lifetime charge, known as a “chargeable lifetime transfer”, is currently £331,000:
- The nil-rate band is £325,000
- The annual gift exemption is £3,000
- The annual gift “carry forward” is a further £3,000.
All these figures are correct as of January 2022.
The advantage of settling this type of trust now is that it starts the “seven-year clock”. This relates to the seven years after making a gift that IHT remains chargeable. The charge tapers down so that the value settled will fall out of the estate after seven years.
Trusts can provide you with very attractive IHT planning opportunities where you require a regular income from the overall value of your assets.
By setting up a discounted gift trust (DGT) you can determine a level of income that you want to take from the trust.
You do this by setting up an investment with the value of assets you put in such a trust.
We often recommend an offshore bond for this purpose for tax planning reasons. They offer the flexibility of you being able to withdraw up to 5% of the value of the bond without any of the gains being immediately chargeable for tax and the underlying income and gains within the trust are not immediately chargeable to the trustees either.
HMRC publish guidelines outlining how DGTs should be valued. These are based on variables such as:
- The initial investment into the trust
- The level of fixed income withdrawals
- The lifestyle, health, and age of the assured.
The “discount” is the difference between the initial value settled into the DGT and the amount subject to IHT. In simple terms, the discount is derived, using he HMRC guidelines above, from the level of income that it is reasonable to expect the settlor will withdrawal until their mortality age. The effect of this can be an immediate and potentially significant reduction in your IHT liability.
Once the trust is established, you can’t access the ‘capital’ – this will be ultimately paid to the beneficiaries – but you will receive the regular, predetermined income from the bond for the rest of your life or until the trust assets are exhausted.
You are able to appoint your children as the potential beneficiaries of a DGT and they will become entitled to any capital remaining in the trust after your death.
Trusts of this kind can be very complicated to set up, and we would always recommend that you get advice from an expert to ensure everything is arranged correctly.
Retain access to capital by using a loan trust
One potential downside of using trusts is that you lose control of the assets within the trust. This can be awkward if there’s a change in your financial circumstances.
A way to avoid this is by using a loan trust. This means you make an interest-free loan to a trust and, while the outstanding loan remains your asset and forms part of your estate, any capital growth achieved on the investments is not included in your estate, although outside of your ownership.
So, you can still retain access to the capital (the loan) and use this to fund part of your future expenditure requirements.
After the mandatory seven years previously mentioned, you can then consider settling a proportion of the loan into one of the other types of discretionary trusts described above, which are more efficient from an IHT perspective.
Again, you may appoint your children as the potential beneficiaries of the trust, although for this specific trust they could be entitled, either absolutely or at the discretion of the trustees (depending upon the trust wording), to assets from the capital growth.
Get in touch
These trust options are not necessarily to be used in isolation and the true art of financial planning is to help advise you on how a combination of such trusts may be used alongside other estate and IHT strategies to meet your overall goals and objectives.
If you’d like to talk through your requirements, please contact us by email or, if you prefer to speak to us, you can reach us in the UK on +44 (0) 208 0044900 or in Hong Kong on +852 39039004.