How does setting up a trust help avoid inheritance tax?
When we talk about inheritance tax (IHT), trusts can be really helpful in reducing taxes and keeping wealth safe. This article will explore what trusts are, how they can help with inheritance tax, and why experts called financial advisers are important in managing these special money arrangements.
Let’s dive in and understand!
What is a trust?
A trust is like a special box that a person in charge (called a trustee) takes care of for others (beneficiaries). There are different types of trusts for different needs and situations. Here are three types:
- Discretionary Trusts
- Interest in Possession Trusts
- Bare Trusts
Different types of trusts and their tax implications
The type of trust used affects how inheritance tax is applied and whether additional charges arise. As mentioned above, there are three types of trust that help to avoid inheritance tax.
Let’s take a look at each.
Bare Trusts
The assets belong to the beneficiary outright, meaning they avoid IHT after seven years. However, the beneficiary has full control once they come of age.
Discretionary Trusts
These offer flexibility, allowing trustees to decide how assets are distributed. They can trigger a 20% tax charge if the initial transfer exceeds £325,000 and may face periodic IHT charges.
Interest in Possession Trusts
A beneficiary receives income from the trust while the assets remain protected. The trust is still subject to IHT, but planning can help reduce liabilities.
In the following sections of this guide to using trusts to reduce or avoid inheritance tax, we look at who can help you with the process, some potential drawbacks, and other key information.
How can trusts help avoid inheritance tax?
Using trusts is like playing a smart game with taxes and it certainly can be one of the ways to avoid inheritance tax.
When you put things into a trust, they usually don’t count as part of your estate when it’s time to pay taxes. This can make your estate worth less in the eyes of HMRC – and that means less inheritance tax!
One thing to consider is that if you put some assets into a discretionary trust and wait for seven years, they usually don’t get taxed at all. This can help a lot in passing your wealth down to family and / or friends.
Please note, this is a simple explanation. There are lots of rules and laws surrounding inheritance tax, so always seek the advice of an experienced financial adviser.
Related articles on inheritance tax & estate planning
Enjoying this article so far? Here are some more articles covering the topic of IHT, protecting your wealth, and estate planning:
In the next sections of this short guide on using trusts to avoid IHT, we look at any potential obstacles you may face, and the importance of seeking professional inheritance tax advice.
The role of trustees in managing inheritance tax risks
Trustees play a critical role in managing assets and ensuring tax compliance.
They must:
- Keep accurate records of all trust transactions.
- Ensure distributions are made in line with the trust’s terms.
- Be aware of periodic and exit charges to avoid unnecessary tax.
- Work with financial advisers to keep the trust tax-efficient.
Poor management can result in unexpected IHT bills or legal challenges. Choosing the right trustees is essential for protecting assets long-term.
How trusts compare to other inheritance tax planning strategies
Trusts are one way to reduce inheritance tax, but they aren’t the only option. Other methods may be more suitable depending on the size of the estate, financial goals, and the level of control required.
Gifting
Outright gifts fall outside the estate after seven years but offer no control over how they are used. If you are keen to understand more about gifting, and the seven-year rule, keep reading, as that’s covered in the next section of this guide to setting up trusts to avoid inheritance tax.
Pensions
Historically, pensions sat outside of your taxable estate, making them a tax-efficient way to pass on wealth. However, changes to inheritance tax, announced in The Budget 2024, mean they are now part of your IHT calculation.
Business property relief (BPR)
Certain business assets qualify for up to 100% inheritance tax relief if held for at least two years. Again, there have been changes to how BPR can be used to avoid inheritance tax, so it’s essential to get professional advice before making any decisions.
While trusts provide flexibility and control, they come with tax and administration responsibilities. A balanced estate plan may use multiple strategies together.
Choosing the right trust depends on tax efficiency, control, and long-term financial objectives.
How trusts work with the seven-year rule
The seven-year rule applies to many trusts, but not all gifts into trust are treated equally. If a trust is classed as a Potentially Exempt Transfer (PET), no IHT is due if the settlor survives seven years.
It’s important to note, that transfers into certain trusts, like Discretionary Trusts, may trigger an immediate 20% charge if they exceed the nil-rate band (£325,000).
Furthermore, Taper Relief can reduce tax on gifts made between three and seven years before death. Finally, placing assets in trust requires careful planning to ensure they fall outside the estate at the right time.
Are there any drawbacks to using trusts to avoid inheritance tax?
Even though trusts can be used to reduce or avoid inheritance tax, there are lots of details to consider, as well as the cost involved.
Trusts also have some charges and fees based on the value of the assets you put in them. Knowing about these taxes and fees is really important if you want to use trusts the right way.
Common misconceptions about setting up trusts for IHT planning
Many people assume that trusts automatically remove inheritance tax, but this isn’t always the case.
- “Trusts eliminate IHT completely” – Some trusts still incur tax charges, including periodic and exit charges.
- “Only the wealthy use trusts” – Trusts benefit anyone looking to protect assets and manage tax efficiently, not just high-net-worth individuals.
- “Once assets are in a trust, they can’t be touched” – Some trusts allow access to income while protecting capital.
Understanding these details ensures trusts are used effectively without unexpected tax issues.
Combining trusts with Life Insurance
A trust can be used to hold a life insurance policy, ensuring the payout stays outside the estate and isn’t taxed at 40%.
Here is a short overview:
- The policy pays out directly to beneficiaries without waiting for probate.
- Funds can be used to cover any inheritance tax liability, preventing the need to sell assets.
- Because the trust owns the policy, the proceeds are not counted within the estate.
This strategy is often used alongside other IHT planning methods to ensure beneficiaries receive the full value of an estate.
Trust planning for high net-worth individuals
Larger estates often require advanced trust planning to manage tax efficiently.
Here are some examples:
- Offshore trusts can offer tax advantages for non-UK domiciled individuals, but they are under strict HMRC scrutiny.
- Family Investment Companies (FICs) provide an alternative to trusts, allowing assets to be passed down while maintaining control.
- Multiple trusts can be set up to spread assets and avoid hitting the nil-rate band in one go.
For high-net-worth individuals, trusts need to be carefully structured to balance tax efficiency with access and control.
Who can help?
Getting help from people who know a lot about inheritance tax is really important when you want to make or use a trust. These experts are called inheritance tax advisers or estate planners. They are typically a financial adviser who specialises in estate planning and inheritance tax.
An experienced financial adviser will really understand the rules and laws about trusts and taxes. They make sure the trust is set up to help you achieve your goals – such as reducing IHT.
They also help with things like picking the right person to take care of the trust and keeping things running smoothly.
Related reading: Six things we can learn from the wealthy.
Is it a good idea to put your house in a trust to avoid inheritance tax?
Making a trust for your house can be a good plan to reduce inheritance tax. However, you need to think carefully and ask experts for advice. Before we move on, it’s pertinent to note that another way to avoid IHT is to gift your house to your children, however, there are many things to consider if you are looking at this option.
When your house is in a trust, it may not form part of your taxable estate. Nevertheless, there are important things to think about such as what type of trust to use and any taxes you might need to pay.
Trusts can be really helpful, but they can also be a bit tricky. Talking to an inheritance tax planner can help you decide if putting your house in a trust is right for you.
Summary: Using trusts to avoid inheritance tax
Trusts are like secret tools for playing the tax game smartly. They can help reduce the amount of inheritance tax and keep your wealth safe for the future. But making and using trusts is like doing a puzzle – it’s not always easy.
That’s why talking to experts who know about inheritance tax is so important. These experts can guide you and make things simpler. With their help, you can use trusts to make sure your loved ones get what you want them to have.
As a result, you will have peace of mind, knowing your family’s wealth is protected.
Frequently asked questions (FAQs)
Keen to learn more about setting up trusts to avoid inheritance tax? Want to learn more about how how to avoid inheritance tax?
Read through this set of handpicked FAQs.
How does setting up trusts help avoid inheritance tax?
Trusts remove assets from your estate, reducing the amount subject to inheritance tax. If the trust is structured correctly, assets will not count toward the estate after seven years. Some trusts also allow income distributions while keeping capital protected. However, tax rules vary, so professional advice is essential.
What are the different ways to avoid inheritance tax?
There are several ways to reduce or eliminate inheritance tax legally. Gifting assets at least seven years before death removes them from the estate. Trusts protect wealth and provide tax advantages. Pensions are usually outside the taxable estate. Business Relief and Agricultural Relief can reduce tax on certain assets. Life insurance placed in trust ensures tax-free payouts to cover liabilities. A well-structured estate plan combines these strategies for maximum tax efficiency.
Can I still access assets placed in a trust?
In most cases, once assets are placed in a trust, the settlor loses direct control. However, some trusts allow beneficiaries to receive income while the capital remains protected. If the settlor retains benefits from the trust, HMRC may still include the assets in the taxable estate.
What’s the difference between estate planning and inheritance tax planning?
Estate planning is a broad strategy for managing and passing on wealth, including wills, trusts, and asset distribution. Inheritance tax planning specifically focuses on reducing tax liabilities on the estate. While estate planning ensures assets go to the right people efficiently, inheritance tax planning minimizes the tax due. Both work together to protect wealth and ensure beneficiaries receive as much as possible.
How does the seven-year rule apply?
If assets are placed in certain trusts and the settlor survives seven years, they usually fall outside the estate. However, some trusts, such as Discretionary Trusts, may trigger an immediate 20% tax charge if the transfer exceeds £325,000. Understanding these rules helps avoid unexpected tax costs.
Are there any inheritance tax risks when using trusts?
Yes, trusts can still incur tax charges if not managed properly. Some trusts are subject to ten-year periodic charges, while others may have exit charges when assets are distributed. If a trust is incorrectly structured, the assets could still be counted for inheritance tax purposes.
Can setting up trusts protect assets from care home fees?
Trusts can help protect assets from care fees, but local authorities can challenge them if they believe assets were transferred deliberately to avoid assessments. The structure and timing of the trust are crucial to ensuring protection while staying compliant with financial regulations.
What are the benefits of getting inheritance tax advice?
Expert advice helps structure assets efficiently, reducing unnecessary tax. A specialist can identify tax reliefs, recommend the best use of trusts, and ensure gifts and investments are managed correctly. They also help navigate complex rules, preventing costly mistakes. Without guidance, estates may be taxed more than necessary, reducing the amount passed to beneficiaries. Proper planning ensures wealth is preserved and inheritance tax liabilities are minimised.
How do trusts affect capital gains tax (CGT)?
Transferring assets into a trust can trigger CGT if the value has increased. However, certain trusts qualify for holdover relief, which allows the gain to be deferred until the assets are sold by the beneficiary. This helps manage tax efficiently.
Can a trust help with business succession planning?
Yes, a trust can ensure business assets are passed smoothly to the next generation. If structured correctly, Business Relief may reduce or eliminate inheritance tax on qualifying business assets. This prevents a sudden tax bill that could force the sale of a family business.
Are offshore trusts a legal way to avoid inheritance tax?
Offshore trusts can offer IHT advantages for non-UK domiciled individuals, but they are closely monitored by HMRC. If a UK resident transfers assets offshore but retains any benefits, they may still be liable for tax. Expert advice is essential to stay compliant.
