If you want to make sure that more of your wealth is passed on to your loved ones, setting up a trust or gifting your money can help reduce any inheritance tax (IHT) due on the value of your estate. Here we’ve explained some of the tax implications and the rules around trusts and gifting.

In the years to come, thousands more British homeowners could leave behind an IHT bill on their estate. According to statistics from Her Majesty’s Revenue and Customs (HMRC), IHT receipts from April 2021 to February 2022 climbed to a record high of £5.5 billion – that’s £700 million higher than the same period the year before.

And with house prices hitting record highs in recent months, more families have homes that will push the value of many estates well beyond current IHT tax-free thresholds. With that in mind, it’s become increasingly important to consider how you can plan for IHT – and make sure more of your estate is left to your loved ones.

Trusts have been established in UK law since the 12th Century, and are still used today to help decide what happens to family wealth

What are the current IHT thresholds?

There’s no IHT to pay if the value of the deceased’s estate is less than £325,000. And, if you choose to give away your family home to your children or grandchildren, this increases your IHT tax-free threshold to £500,000 per individual.

If you are married or in a civil partnership, you can leave your estate to your spouse or civil partner, and their estate will benefit from any unused IHT allowances. However, with more people owning homes well over the £500,000 threshold, many are likely to see their estates hit with an IHT bill. As a result, some are making use of trusts to protect their assets during their lifetime and ensure a greater proportion of their estate gets passed on.

Understanding the language of trusts

Trusts have been established in UK law since the 12th Century, and are still used today to help decide what happens to family wealth. There are several different types of trust, but they all usually refer to:

  • the ‘settlor’: the person who owns the estate and sets up the trust
  • the ‘trustee’: the person nominated by the settlor to look after the trust
  • the ‘beneficiaries’: the person or people who will ultimately receive the assets held within the trust

Why do people create trusts for their wealth?

Trusts are particularly useful for families with generational wealth, or where family relationships are more complex. For example, people often use trusts when:

  • They want to leave assets to their children or grandchildren, but want them only to access those assets after reaching a certain age.
  • They have named specific beneficiaries in their will, but they would also like to impose restrictions on how their estate is allocated to those beneficiaries.
  • They would like to nominate a person to receive an income from certain assets – or to have ownership rights over a property – during that person’s lifetime, but they also want the assets to be passed on to different beneficiaries in the future.

Discretionary trusts are often used to pay for a specific need, such as university fees

Common types of trust

Bare Trusts

The most popular form of trust used today is called a ‘bare trust’. With a bare trust, the assets are held in the name of the trustee, and they are responsible for those assets until the beneficiary turns 18 (16 in Scotland). However, the beneficiary has the right to all of the capital and income held within the trust. If you are considering setting up a bare trust, it’s important to note that any assets placed into the trust will become exempt from IHT provided the settlor lives for at least seven years after the trust is set up.

Discretionary trusts

The second most popular form of trust is a ‘discretionary trust’. These are used when the settlor wants to leave money for a group of beneficiaries, such as grandchildren, but the trustee has much more control over managing those assets and making use of the trust’s capital and income.

People often use discretionary trusts to help invest for a specific need, such as to pay for university fees or to pay for the care of a beneficiary who may not be able to manage the money themselves. Similar to a bare trust, the assets within a discretionary trust become exempt from IHT seven years after setting up the trust. However, charges may be payable when the trust is first created, at ten-year intervals, and whenever money is paid out of the trust to beneficiaries.

Discounted gift trusts

Another common form of trust is known as a ‘discounted gift trust’. These are particularly useful if the person setting up the trust wants to reduce their estate’s IHT liabilities, but does not want to lose full access to their wealth while they are alive. With a discounted gift trust, the settlor makes a ‘gift’ into the trust, but can still receive capital payments from the trust during their lifetime. After the settlor dies, the capital payments cease, and the remaining amount in the trust becomes subject to IHT again.

Immediate Post Death Interest trust

Finally, an ‘Immediate Post Death Interest’ trust gives a named beneficiary a ‘life interest’ in the assets that are held within the trust. This can include the right to live in a property – or even to collect a rental income from that property – for the rest of the beneficiary’s lifetime. The asset can then be passed on to different beneficiaries. This is often the case where the settlor has children from a first marriage and has remarried, but the settlor wants the children from the first married to inherit the family home after the second spouse has died.

All gifts between spouses or civil partners are free from inheritance tax

Making gifts to reduce your IHT bill

You can also ‘gift’ your money away to reduce the value of your estate. HMRC gives everyone an annual £3,000 gifting allowance, called the ‘annual exemption’. You can carry over your £3,000 annual exemption to the following year if you don’t use it, but only for one year.

All gifts between spouses or civil partners are free from IHT.

Wedding gifts to certain limits (up to £5,000 for your child, £2,500 for your grandchild or great-grandchild, and up to £1,000 for anyone else) are also IHT-free. You can also make multiple small gifts of up to £250, if you haven’t given them a gift as part of your £3,000 annual exemption.

Potentially exempt transfers and the seven-year rule

Any gifts larger than £3,000 could trigger an IHT bill, and these are called ‘potentially exempt transfers’. A potentially exempt transfer will fall outside of a person’s taxable estate (in other words, it won’t be subject to IHT when they die) provided the person who made the gift lives for at least seven years after the gift was made.

The amount of inheritance due on a potentially exempt transfer is reduced on a sliding scale. So, if the gifter died within three years of making the gift, IHT would be charged at 40% of the value of the gift, whereas if they died between years six and seven, IHT would be charged at just 8%.

Final points to remember about trusts and gifting

While trusts are an effective way to keep control over your assets, and who will benefit from them, they do have limitations. For example, in most instances, assets placed into trust only become fully exempt from IHT after seven years. Should you die before then, the assets will again form part of your taxable estate.

The same is true for gifting large amounts. And whatever gifts you choose to make, it’s important to keep records. These will prove essential when your executor is dealing with your estate and claiming IHT exemption for your beneficiaries.

Amber River Financial Planner

Remember too that HMRC tax rules are complex and can change at short notice. Before making any significant decisions about your estate, it’s a good idea to talk to an Amber River independent financial planner. They will be able to talk you through the process, highlight any tax implications, and ensure the actions you take are in the best interests of you and your family.

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