What’s your perception of trusts? Have you set up a trust already, perhaps in the name of a younger loved one to whom you want to leave a nest egg? Or are you thinking about doing so but aren’t sure where to start?
Perhaps you have a negative view of trusts, and see them exclusively as a tool for the ultra-rich?
In reality, trusts are a hugely useful estate planning tool. You (known as the “settlor”) put money or assets into trust for your beneficiaries. This is then overseen by one or more individuals you choose, known as “trustees”.
Provided you use the right kind of trust and set it up correctly, they can be especially effective for achieving two specific goals:
- Setting wealth aside for beneficiaries while generating further income.
- Protecting your estate against Inheritance Tax (IHT).
When used strategically, certain trusts can help generate income for either yourself or loved ones (or both), as well as mitigate your estate’s IHT bill after you pass away.
Specifically, the trusts you might want to think about are discounted gift trusts and loan trusts – don’t worry, we’re going to explain how these work.
Here’s what you need to know about how these trusts function, how you could use them to derive an income while shielding your wealth from IHT, and a few things to consider before you do.
Discounted gift trusts can provide an income while reducing Inheritance Tax
To begin with, let’s look at discounted gift trusts. An effective estate planning tool, discounted gift trusts could provide you with a regular income while reducing your estate’s IHT liability.
In effect, you “gift” funds into the trust – usually in the form of a life assurance investment bond – and then assign a trustee (or trustees) to oversee the trust. This can be structured in one of two ways:
- An absolute or “bare” trust, in which trustees manage the trust in line with the wishes outlined in your trust deed, until the beneficiaries are entitled to the funds.
- A discretionary trust, where the trustees decide which beneficiaries receive money from the trust, as well as when and how much.
For our purposes, imagine that you’re setting this up as discretionary, making it a discretionary gift trust.
In this type of trust, you have no rights to the value of the bond within the trust, as this now technically belongs to your beneficiaries.
But crucially, you retain a right to make regular withdrawals, continuing until you pass away or the trust assets run out. So, it offers a method of ensuring you can continue to receive an income from the gift.
After you die, the capital is passed to your beneficiaries at your trustee’s discretion. With this in mind, there are also IHT benefits to this structure.
Firstly, there’s the “discounted” aspect. Essentially, when you set up the trust, part of the gift immediately falls outside of your estate for IHT purposes.
Because you are taking withdrawals from the bond, you are retaining an element of the gift you are making, as it won’t go to your beneficiaries. So, part of your gift is given a discount that doesn’t attract IHT.
This discount is calculated by estimating the value of the withdrawals you are expected to receive during your lifetime, using factors such as your age and health, and the rate at which you are withdrawing funds. There are also complex formulae involved here to determine what’s called the “present value”.
That figure is then deducted from your overall gift into the trust. After that, only the remaining value is potentially subject to IHT – and that is not certain either.
Gifts into discretionary gift trusts are considered chargeable lifetime transfers (CLTs), and these may be subject to IHT. These differ from bare trusts, where gifts are called “potentially exempt transfers” or “PETs”.
But before IHT is due on your estate, you have a tax-free nil-rate band, which in 2025/26 is the first £325,000. Your estate may also benefit from the residence nil-rate band of £175,000 if you leave a primary residence to a direct descendant. Funds in excess of these thresholds are usually liable for IHT at 40%.
Gifts such as CLTs are usually the first element of your estate assessed against your nil-rate band. So, there will be no IHT to pay if your gifts do not exceed the nil-rate bands.
If they do, the portion of the gifts that exceeds the threshold may be subject to an immediate 20% charge. Furthermore, if you die within seven years of making the gift, it will be reassessed at the full 40% – if you have already paid the initial 20% charge, only a further 20% charge will be added.
There may also be a tapered rate of IHT if you die between three and seven years after making the gift. This is a rolling seven-year period for each CLT you make into a trust.
This seven-year rule applies because each CLT is assessed together with any other gifts you have made in the previous seven years, rather than operating on a separate seven-year clock for each trust gift.
Even so, the discounted sum from your gift, combined with the potentially lower tax rate for CLTs that fall outside your estate, can make these trusts an effective IHT planning tool.
Loan trusts function similarly, but with other features to consider
Now let’s compare discounted gift trusts to loan trusts.
As with discounted gift trusts, loan trusts can also be absolute or discretionary.
When you place funds into a loan trust, you’re effectively loaning them to the trustees. They then invest the funds – also often in an insurance bond – with the goal of growing it for the beneficiaries. You can take part repayments on the loan over time as tax-deferred withdrawals, offering you a regular income.
In this respect, while the mechanism of how it works is different, the income you can receive functions similarly to the discounted gift trust.
However, one of the key differences here is that the amount you pay into the trust is a loan, not a gift. As a result, the loan remains your property, and you can call back and access the original capital at any time.
That also means the principal amount remains in your estate and is potentially subject to IHT, as are the loan repayments which effectively go back into your estate. There’s no discount, CLT, or rolling seven-year period to contend with – unless you waive the loan later, in which case it becomes a gift. In a discretionary trust, this is a CLT, whereas it would be a PET in a bare trust.
Crucially, though, the growth of those funds will leave your estate and become the property of your beneficiaries. These returns are then excluded from your estate for IHT purposes.
So, a loan trust can be useful if you want to maintain an income from your wealth and avoid IHT to an extent, while retaining control of the funds as a whole.
Seek advice before setting up trusts
If these trusts sound like they could be useful to you, then you may want to consider putting them in place. But before you do, it’s vital to seek professional advice.
Trusts are highly complex arrangements, and placing assets in them is often irreversible. So, before you commit to placing assets in trust, you need to be sure that it’s the right decision for you.
Similarly complicated is calculating the amount of IHT due, when it is payable, and who should pay it. As such, it’s often worth seeking advice if your goal is to mitigate your estate’s IHT liability.
With this in mind, professional guidance from a financial planner can help you find the right solutions.
Our team can support you in defining a trust strategy that works for you, taking your goals, financial circumstances, and family dynamics into account.
Get in touch
To speak to one of our advisers, email help@fourseasonsfp.co.uk or call us on +44 (0) 13724 04417.
Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
All information is correct at the time of writing and is subject to change in the future.
Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
The Financial Conduct Authority does not regulate estate planning, trusts, or will writing.
Remember that taper relief only applies to gifts in excess of the nil-rate band. It follows that, if no tax is payable on the transfer because it does not exceed the nil-rate band (after cumulation), there can be no relief.
Taper relief does not reduce the value transferred; it reduces the tax payable as a consequence of that transfer.
