Trusts And Inheritance Tax: Why Playing The Long Game Can Pay Off

When contemplating passing wealth on to the next generation, inheritance tax is often one of the biggest challenges families in the UK face. Broadly, it is charged on the value of a person’s assets when they die, after taking account of their available nil rate band of up to £325,000, along with any other reliefs and exemptions. Assets above that level, where no exemption or relief applies, are taxed at 40% — so for families hoping to preserve wealth for children and future generations, the impact can be significant. Despite not being as effective as they once were, the use of trusts can still be a very useful tool for families looking to achieve this, so long as the right level of planning is in place. 

Generally, the most effective way to mitigate inheritance tax is to give assets away so that they no longer form part of your estate when you die. For assets to leave your estate for inheritance tax purposes, you must survive for a period of 7 years from the date of gift and you must relinquish any benefit derived from the gifted asset.

For most people, the idea of gifting significant capital to their children or grandchildren can raise some legitimate concerns, particularly in relation to the detrimental effect having access to large sums of money can have on younger people. Even if the recipient of the gift is thought to be financially responsible, concerns may still arise in the form of potential divorce or personal insolvency for the recipient. This would expose the gift to payment to an outside party, rather than it being preserved fully within the family.

Gifting assets to a discretionary trust for the benefit of your family can be a useful solution for the concerns mentioned. This has the effect of making the assets available to a select group of beneficiaries, whilst ringfencing them against any unwanted exposure. Although you would be giving up the benefit of those assets, you could still remain in control of them as a trustee of the trust.

There is a catch, however. Assets gifted to a discretionary trust are regarded as chargeable lifetime transfers for inheritance tax purposes, meaning they attract a charge at the lifetime rate of inheritance tax of 20%. The practical effect of this is that, if you want to gift assets to a discretionary trust, you are limited to a gift up to the value of your nil rate band of £325,000, with a 20% charge being applied to anything over and above that. The used value of your nil rate band is then replenished if you survive 7 years after the date of each gift. This can be off-putting for people looking to gift more substantial sums.

The practical effect of these rules is that an individual can gift £325,000 to a discretionary trust every 7 years, without paying any inheritance tax upfront. Couples can both gift their available nil rate band to the same trust, meaning collectively they can gift £650,000 to trust every 7 years. This is, therefore, an exercise of forward planning and patience. If high-net-worth individuals or couples start planning early enough, they can protect and preserve substantial sums of family wealth for their children and future generations. If you have the time and patience to play the long game, the rewards can be significant!

Let’s take the example of a couple with a combined worth of £5m. If the 2^nd of them to die did so with all of those assets still in their name, their entire estate would suffer an inheritance tax charge of 40%, after deduction of their combined nil rate band of £650,000. However, if that couple had gifted £650,000 to a trust 21 years before the first death and then again 14 and 7 years before that date, they would effectively pass on £1.95m to the next generations, free of inheritance tax. The remaining estate of £3.05m would suffer inheritance tax at 40%, again after deduction of their combined nil rate band of £650,000.

For individuals and couples who can afford to make these gifts every seven years, the inheritance tax savings can be substantial. The message is simple: plan early, be patient, and you can preserve more wealth for your family.