Trusts are a useful way of controlling what happens to your assets when you die, but did you know that you can use a trust to avoid inheritance tax?
With careful planning, the portion of your estate that gets lost in tax can be reduced or avoided altogether.
However, the rules around inheritance tax are complex and it could end up costing you more depending on the type of trust, so it is best to get tailored advice before deciding what is right for you.
In this article, we cover the ins and outs of using a trust to cut your inheritance tax to leave your loved ones with more.
. What is Inheritance Tax?
. What is a Trust?
. Using a Trust to Avoid Inheritance Tax
. What are the Different Types of Trusts?
. Overview
. Need More Advice?
Contents
What is Inheritance Tax?
Inheritance tax (IHT) is a tax that can be applied to your estate (money, property, investments and belongings) if it is valued over a certain amount.
Following your death, the executors of your will need to calculate the value of your assets and deduct any liabilities, with the remainder being liable to inheritance tax.
If your estate is worth under £325,000, then it sits in the “nil-rate band” and you pay no tax. But if it is worth more than £325,000, then everything above that threshold is subject to inheritance tax at a rate of 40%.
For example, if someone leaves an estate worth £550,000, then £225,000 of that will be subject to inheritance tax (unless certain circumstances apply). This means that their beneficiaries must pay £90,000 in tax (40% of £225,000), leaving them with £460,000 (£550,000 minus £90,000).
What is a Trust?
Typically, a trust is a legal arrangement where you give your cash, property, or investments to someone else, who will manage them for the benefit of a third person. For instance, you might put some of your savings in a trust for your children or grandchildren.
To understand what a trust fundamentally is, it is important to know the two key roles:
Trustee – the appointed person whose job is to run and manage the trust responsibly. The trustee legally owns the money or assets in the trust, so it is crucial that you carefully choose someone you know well and have confidence in their abilities to manage your assets in a way you would like.
Beneficiary – the person who the trust is set up for, with the assets in the trust held for the beneficiary’s benefit.
Using a Trust to Avoid Inheritance Tax
When you put assets in a trust, you no longer own them provided certain conditions are met. This means that it is outside your estate and will not be included when the amount of inheritance tax you owe is calculated, so long as you live for seven years after placing the assets into the trust.
Some trusts are subject to their own Inheritance Tax though and you could end up paying more depending on the type of trust you have. They are subject to three separate inheritance taxes:
- Entry charge
The entry charge is paid when assets are moved into a trust. They can either be a gift made during someone’s lifetime or a transfer that reduces the worth of their estate.
- Exit charge
The exit charge is paid when a trustee pays out of the trust to a beneficiary, with the charge being based on a percentage of the asset’s value.
However, where payments of income are transferred to beneficiaries, inheritance tax is not applicable as the beneficiaries will be liable for income tax instead.
- Ten-Year charge
The ten-year charge (also referred to as the periodic charge) is payable when the trust contains relevant property and where the value is over the nil-rate band.
For example, with a discretionary trust (one of the most commonly used trusts for inheritance tax planning), you must pay 20% inheritance tax upon setting it up for anything above the nil-rate band. The assets in the trust will need to be revalued each decade, with a 6% applicable charge if the value is over the threshold.
It is charged on the day before each ten-year anniversary, but there is no charge except an exit charge if all the assets are transferred to the beneficiary before the ten years is up.
Once the trust is closed or any assets are taken out of the trust, there will be an additional charge of up to 6% based on the most recent ten-year valuation, which will be charged on a pro-rata basis.
Putting property into trust to avoid inheritance tax
People commonly ask: can I put my house in trust to avoid inheritance tax?
In short, yes, a trust can be a way to avoid paying inheritance tax on your property. As with any other assets, it is not classed as part of your estate once it belongs to a trust.
It is worth bearing in mind though that transferring assets into a trust is not without tax implications – each type of trust is taxed differently for each party involved. The same applies for transferring property into a trust.
Types of trust
There are many different types of trusts to choose from, such as a bare trust, interest in possession trust, discretionary trust, accumulation trust, mixed trust, will trust, and non-resident trust.
Each have their own advantages and disadvantages, depending on your situation.
- Bare Trust
With a bare trust, the beneficiary becomes entitled to all the assets in the trust, so long as they are mentally capable. If they are not eighteen years old or over (or sixteen years old in Scotland), trustees must manage the assets until the beneficiary is of age.
Bare trusts are widely used by parents and grandparents to transfer assets to their children or grandchildren. Once the beneficiary is old enough, they can take possession of the assets at any time.
Possibility of Inheritance Tax liability: the transfers into a bare trust may be exempt from inheritance tax if the person making the transfer is alive seven years after making the transaction.
There is no tax implication for the person who sets up the bare trust, as they give up their legal title to the assets once they are transferred to the trust.
- Interest in Possession Trust
In an interest in possession trust, the trustee must distribute all trust income to the beneficiary, who can receive the income instantly but does not have a right to the cash, property, or investments that generate that income.
The beneficiary will also need to pay income tax on the income received from the trust.
A good example of using an interest in possession trust is if you created one for all the shares you owned: the terms could instruct that the income from the shares go to your partner when you die. As the income beneficiary, your partner would have an “interest in possession” in the trust, but would not have a right to the actual shares.
In the event of your partner dying, the shares would then pass to your children.
Possibility of Inheritance Tax liability: there is no inheritance tax applicable on assets that are transferred into an interest in possession trust before 22nd March 2006. However, assets transferred on or after this date may be subject to the ten-year inheritance tax charge.
- Discretionary Trust
Trustees have complete power over how the assets in a discretionary trust are distributed to the beneficiaries. Tr
Trustees can choose what is paid (income or capital), which beneficiary to pay, payment frequency, and what requirements a beneficiary must meet.
For example, you could set up a discretionary trust for your grandchildren and leave it to the trustees (who could be the grandchildren’s parents) to decide how the income and capital is split between the grandchildren.
Possibility of Inheritance Tax liability: entry charge, ten yearly charges, and exit charges are possible due to the flexible nature of discretionary trusts. Also, all income received by beneficiaries is dealt with as though it has already been taxed at 45%.
- Accumulation Trust
Similar to discretionary trusts, trustees can acquire income within an accumulation trust and add it to the trust’s capital. They may be able to pay income out too.
Possibility of Inheritance Tax liability: all income received by beneficiaries is dealt with like it has already been taxed at 45%.
- Mixed Trust
Mixed trusts vary in their nature due to the fact they combine elements from different types of trusts. For example, a beneficiary might have a right to income (interest in possession trust) but have no control over payment frequency (discretionary trust).
Possibility of Inheritance Tax liability: the trust is separated into parts that are taxed individually.
- Will Trust
Someone may request in their will that all or parts of their assets are placed into a trust. To write one in your will, you need to clearly state what the assets of the trust are, who the trustee and beneficiaries are, and when the trust becomes active (i.e., only when you die).
Possibility of Inheritance Tax liability: the personal representative of the deceased person must make sure that the trust is administered correctly and that all taxes have been paid. Additionally, the trustees must ensure that any future charges are subject to inheritance tax.
- Non-Resident Trust
A non-resident trust is one where the trustees are not residents in the UK for tax reasons.
Possibility of Inheritance Tax liability: a deceased person’s estate must be valued by finding out whether they made any transfers in the seven years before their death. If they did and paid 20% inheritance tax on the transfers, then you will need to pay 20% more from the estate.
Overview
Trust law is complicated. On the surface, setting up a trust to avoid inheritance tax sounds appealing, but you should never set one up for the sake of tax advantages.
With so many types of trusts subject to different charges (entry, exit, and ten-year charges), the trust might avoid one type of tax but will likely be subject to another.
Need More Advice?
It is crucial to get professional advice to make sure you set up your trust correctly. At Legacy Wills & Probate, we ensure that you and your family are taken care of in the best way possible.
We give you a caring and personal service in the handling and administration of creating a will, and with our many years of expertise, you can trust us for stress-free advice at a time of important and difficult decision making.
So, whether you want to set up a trust or need guidance on how to avoid inheritance tax, we can help. Don’t hesitate to call our friendly team for guidance or information today.
