Discretionary trusts are a type of trust commonly used in estate planning to provide flexibility in distributing assets to beneficiaries One of the advantages of setting up a discretionary trust is that it allows the trustee to have discretion in determining how the assets in the trust are to be distributed This can be particularly useful in cases where the beneficiaries are young or vulnerable, or where there are concerns about how they might manage a large inheritance.
However, when establishing a discretionary trust, it is important to consider the potential impact of inheritance tax (IHT) In this article, we will explore how discretionary trusts are treated for IHT purposes and what steps can be taken to mitigate any potential tax liabilities.
IHT is a tax that is levied on the value of an individual’s estate when they pass away The current rate of IHT in the UK is 40% on the value of the estate above the nil-rate band, which is currently set at £325,000 Assets held in a discretionary trust are also subject to IHT, but the rules for calculating the tax liabilities are slightly different.
When assets are placed into a discretionary trust, a charge to IHT may arise This is known as the “entry charge” and is calculated based on the value of the assets transferred into the trust The rate of the entry charge is currently set at 20% for assets up to the nil-rate band, and 40% for any amount above that threshold.
In addition to the entry charge, discretionary trusts are also subject to periodic charges, which are levied every ten years based on the value of the assets in the trust at that time The rate of the periodic charge is currently set at 6% for assets up to the nil-rate band, and 30% for any amount above that threshold.
One of the key advantages of using a discretionary trust from an IHT perspective is that the assets held in the trust are not considered part of the settlor’s estate for IHT purposes This means that the value of the trust assets is not included when calculating the settlor’s IHT liability on their death.
However, it is important to note that when assets are transferred into a discretionary trust, there may still be potential IHT charges to consider discretionary trusts and iht. In addition to the entry charge and periodic charges, there may also be a charge to IHT when assets are distributed from the trust to the beneficiaries This is known as the “exit charge” and is calculated based on the value of the assets distributed, taking into account any exemptions or reliefs that may apply.
To mitigate potential IHT liabilities when setting up a discretionary trust, there are a number of strategies that can be employed One common approach is to make use of the annual exemption, which allows individuals to gift up to £3,000 each year without incurring any IHT liability This can be a useful way to gradually transfer assets into the trust over time, reducing the potential impact of the entry charge.
Another strategy is to make use of the normal expenditure out of income exemption, which allows individuals to gift surplus income without incurring any IHT liability This can be particularly useful for individuals with a regular income stream that exceeds their living expenses, as it can provide a tax-efficient way to transfer assets into the trust.
It is also worth considering the use of trusts in estate planning more broadly, as there are a number of different types of trusts that can be used to achieve specific objectives For example, a bare trust can be used to transfer assets to beneficiaries outright, while a life interest trust can be used to provide income for a specific individual during their lifetime, with the remainder passing to other beneficiaries on their death.
In conclusion, discretionary trusts can be a valuable tool in estate planning, providing flexibility in distributing assets to beneficiaries while also offering potential tax advantages However, it is important to carefully consider the potential IHT implications when setting up a discretionary trust and to seek professional advice to ensure that the trust is structured in a tax-efficient manner By taking proactive steps to mitigate potential tax liabilities, individuals can maximize the benefits of using a discretionary trust in their estate planning.