Here we take a fictional couple, Barry and Joan, both of whom are UK domiciled, and show how setting up a discounted gift trust reduced their IHT liability from £204,000 to £26,000.
Reducing inheritance tax: a case study of a UK-domiciled couple
- Barry, 65, and Joan, 63, were both born in the UK and moved to Malaysia eight years ago as Barry was sent overseas by his employer, ExxonMobile.
- Barry retires and despite being in good health, dies of a heart attack shortly afterwards following a game of squash. He leaves everything to Joan.
- As Barry and Joan are both UK-domiciled, interspousal transfers during lifetime and on death are not subject to IHT.
- Joan moves back to the UK to live in their family home. 10 years later she passes away leaving everything to their children and grandchildren.
An IHT liability of £204,000 on Joan’s death.
Below left is a summary of Barry and Joan’s assets and below right their IHT liability as things stand:
Exchange rates: GBP = $1.3 / GBP =RM 5.4Points to note:
- £204,000 IHT is due on the estate of £2,312,000
- Pensions are not subject to IHT
- NRB is the Nil Rate Band, the amount of the estate exempt from IHT (£325,000 per person)
- MRNRB is the Main Residence Nil Rate Band (£175,000 per person) applicable to main residences left to direct descendants
- Both Barry and Joan benefit from the NRB and the MRNRB because they are UK domiciled. Barry does not use these on his death so they are inherited by Joan
- The figures assume that any growth on the estate between the two deaths has been spent so the value of the estate remains the same
The Solution: A discounted gift trust
- Barry and Joan set up a joint discounted gift trust for £450,000 from their investments and cash
- They receive £1,500 per month from the trust for life
- The trust immediately removes £160,000 from the estate
- When Barry dies, no IHT is due and the trust stays in force, continuing to pay Joan an income
- Joan lives another 10 years so the full £450,000 paid into the discounted gift trust is outside the estate when she dies (as per the seven year rule regarding IHT and gifts)
This is how the estate broke down when Joan died, and the amount of IHT payable:
This discounted gift trust reduces the proportion of the estate that is liable to IHT and brings the tax bill down from £204, 800 to £26,000.
The tables below show the comparison between the amount of IHT payable with and without the discounted gift trust. As a result of setting up the discounted gift trust, the beneficiaries of the estate are a satisfying £181,800 better off.
If you’d like to explore whether a discounted gift trust or another kind of trust could be used to reduce your UK IHT liability, why not speak to one of our financial advisers? They can study your situation and find an estate planning solution suited to your circumstances.
Disclaimer: Please note that this post is for information only. Trusts and inheritance tax planning are complex subjects with no one-size-fits-all solution. You should always seek expert advice from a qualified professional before making important financial decisions.
What Exactly is a Discounted Gift Trust (DGT)?
A discounted gift trust is when a person transfers money into a gift trust and receives income from the gift trust throughout their lives. The trust fund is generally linked to an onshore bond or offshore investment bond, and the settlor receives regular capital payments provided by the set up of regular withdrawals.
What is a Trust Fund?
A trust fund is created by a person, referred to as the settlor, who places his/her assets in a fund, that is maintained by trustees. The assets in the fund are released to beneficiaries when trustees decide the appropriate terms are met and the settlor dies. If you, as a settlor, put your money in a trust fund, the assets no longer belong to you and are officially in the trustee’s possession.
The Relationship Between Trusts and Inheritance Tax
Accounts frequently refer to inheritance tax as a voluntary tax. The reason for this is that trusts can be utilised to prevent money from being deemed part of an estate. When a person’s estate is then assessed in a given tax year, the assets in the trust funds won’t be considered.
Why are Discounted Gift Trusts Beneficial?
There are various reasons why discounted gift trusts are recommended:
- The settlor will experience an immediate reduction in their estate’s inheritance tax.
- You can choose between getting a fixed absolute trust or a discretionary trust.
- You have various investment bonds and other investment options to choose from.
- The income payments generated by the trust fund are practical for making gifts.
- If you choose to use a discretionary trust, you will not be subjected to exit charges, no matter the nil-rate band. Your investment bond will determine the periodic charges and subtract any applicable discount. If the total yields an amount less than the nil-rate band, no periodic tax will need to be paid.
Disadvantages of Discounted Gift Trusts
Some difficulties associated with discount gift trusts include:
- A settlor is required to be in a position to invest sufficient capital.
- Discount gift trusts aren’t flexible. The withdrawal payments cannot be altered until death occurs. The inheritance tax treatment may be impacted if the settlor doesn’t take the withdrawal.
- A settlor is incapable of surrendering the bond until they die.
- After the client has executed two decades of 5% withdrawals, income tax may be charged.
- The withdrawal size may not be sufficient after a certain period because of a change in lifestyle or inflation.
- The settlor’s lifestyle and whether or not they are in reasonable health will determine the discounts.
How Do Discounts Work?
The provider will calculate the amount the settlor will receive from the trustees if the settlor is in reasonable health. This occurrence is referred to as the bag of rights or the discount. The settlor keeps the discount.
Tax and the Discount/Bag of Rights
The discount or bag of rights is recognised as a gift placed into a trust fund. The trust is then a discretionary or flexible trust and the capital payments made are a chargeable lifetime transfer. If the trust is a bare trust, it may be a potentially exempt transfer. Tax rules will differ depending on many personal factors, such as the settlor’s entitlement, the relevant property regime, and the regulations of the insurance company.
Inheritance Tax and a Discretionary Trust
Besides the tax applied to chargeable transfers, a discretionary trust may be subjected to periodic tax charges every ten years. The value of tax reliefs that may apply depends on the client’s estate and personal circumstances.
The Calculation of the Income
The trust provider will perform a medical underwriting of the settlor. Thereafter, an estimate of the settlor’s life expectancy is established based on their lifestyle and overall health. This information is used to calculate the market value of all future capital payments the settlor will receive. The capital payments are essentially the payments a settlor makes to receive regular payments in the future.
Who Can Benefit from Fixed Absolute Discounted Gift Trusts?
Fixed absolute discounter gift trusts are for those who have established exactly to who their trust capital should be distributed after their death. These clients can then improve on potentially exempt transfers.
Who Can Benefit from Discretionary Gift Trusts?
Those who want to reserve the right to change the trust beneficiaries with time would be best off choosing a discretionary trust. Settlors can then decide how they want their assets distributed at a later stage.
What Is Meant By a Settlors Fund?
A settlor’s fund refers to the regular capital payments and is meant only for the settlor. These regular payments form part of the taxable estate of the settlor. However, there is no inheritance tax payable after the settlor dies, as there won’t be any income rights anymore.
What is Meant by The Beneficiaries’ Fund?
The beneficiaries’ fund is all the capital that the trust holds for the beneficiaries. A beneficiary is a person who will ultimately benefit from a settlor’s trust fund after death occurs. The performance of the investment will determine how much the beneficiary will receive.
Who Will Benefit From Discounted Gift Trusts?
A discounted gift trust is ideal for those who want to receive future payments from their trust fund to spend. These individuals also want to start taking inheritance tax planning measures. If you are considering a discounted gift trust, are need to be in reasonably good health and stay alive for at least seven years.
Who Are Discounted Gift Trusts Unsuited For?
In order to truly benefit from this type of trust fund, a person is required to not be in adverse health and be younger than 90 years of age. It will also help if a person doesn’t have any inheritance tax liabilities. If someone doesn’t necessarily need to make fixed regular payments, they don’t need a discounted gift trust. Those who want more flexibility in when they can draw income from their trust will not benefit from a gift trust. It is also not suitable for people who do not possess the wealth to invest a lump sum to create such a trust. Your financial adviser would be able to offer professional advice on which trusts and investment bonds are best suited for your individual circumstances.
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