Latest Government stats show that more than £4.7bn in tax is paid to the government each year through inheritance tax (IHT). This is a phenomenal amount, especially when we consider that most of the tax could have been mitigated through careful financial planning.
With IHT set at 40 per cent, there is a clear opportunity for advisers to help their clients manage their tax exposure and demonstrate real value in the advice they provide.
There is a perception that trusts are too complicated for clients to understand. Through better understanding, more advisers and clients will realise the effectiveness trusts can have as a financial planning tool. Not only can they significantly reduce a person’s exposure to IHT, they can also ensure the right people get the right proportion of assets at the right time.
How does a trust reduce IHT?
A trust is a way of transferring the legal ownership of the assets, which takes effect immediately. Where a trust is used and the settlor (the person making the gift) is not able to benefit, this will help mitigate IHT.
There are a several different trust types available. Depending on the type of trust chosen, there may be tax to pay when setting up the trust. Gifts into discretionary trusts, where there is flexibility to change beneficiaries, are considered to be chargeable lifetime transfers (CLTs). IHT entry, periodic and exit charges may apply. CLTs may be subject to IHT at a rate of 20 per cent at the outset.
This depends on the amount gifted into the trust and any previous gifts made. When using a bare trust – a type of trust with ‘fixed’ beneficiaries – there is no immediate IHT liability, but if death occurs within seven years IHT may be payable. The amount will reduce in stages over a seven-year period. Once seven years have passed, the IHT liability on the gift goes away.
With so many trusts available it is important to choose the right one, not least due to the potential immediate IHT charge that may apply. A good place to start is to ask the client questions that will help determine whether a trust is appropriate and, if so, which type of trust would be suitable.
Questions to ask your client, having identified an IHT issue:
- Do you require access to income / capital?
- Would you like to gift some or all or your investment?
- Will you require flexible access to the trust fund?
- Will you require fixed, regular withdrawals for the rest of your life?
- Will you want to change, or add to, the trust beneficiaries in the future?
There are two types of trust commonly used in IHT planning.
1. Discount gift trusts (DGT), retains access to withdrawals
The discounted gift trust is a scheme that gives the settlor the ability to make a gift, while retaining a right to withdrawals. The value of the future withdrawals is called the ‘discount’ and takes into account factors such as age and state of health. The significance of the discount is that the estate should immediately be reduced by the value of the discount. Any growth on the trust fund is also immediately outside the estate, and the DGT can be either be a discretionary or bare trust.
In general, where a client is in good health for their age and below the age of 90, there should be an immediate IHT saving.
