The pros and cons of using trusts to reduce Inheritance Tax

Estate planning is a key part of your financial plan, as it’s vital to have an idea of what could happen to your wealth in the future.

This involves Inheritance Tax (IHT) and various ways to reduce the impact of this tax on your wealth after you pass away.

The topic of IHT has become even more prevalent in recent years, as receipts have been rising. Indeed, Professional Adviser reports that HMRC collected £4.6 billion between April and October 2023, a £500,000 rise from the same period a year prior.

By planning ahead and considering ways to reduce IHT early, you could ensure that you pass as much of your wealth on to your loved ones as possible, securing their financial future.

One of the ways you can do so is through trusts. Continue reading to discover how they work, and some benefits and downsides to consider before you use them to mitigate the UK’s “most-hated levy”.

Your family may pay IHT if the value of your estate exceeds the nil-rate bands

In order to safeguard as much of your wealth as possible for your next of kin, it’s crucial to understand the intricacies of IHT.

There is a limit to the amount of your wealth you can pass to your next of kin without incurring an IHT charge. This is called the “nil-rate band”, and in the 2023/24 financial year, stands at £325,000.

On top of this, there is also an additional “residence nil-rate band” that you can apply for if you pass your main residence on to your direct descendants, such as your children or grandchildren. This stands at £175,000 in the 2023/24 financial year, taking your potential total tax-free threshold up to £500,000. Note, this is limited by the value of your estate and is reduced on a tapering basis if your total estate exceeds £2,000,000.

Better yet, both the nil-rate band and residence nil rate bands are transferrable between spouses on first death, meaning that you could potentially pass on up to £1 million between you both without your beneficiaries paying IHT. The IHT liability would only occur on second death.

However, any value that exceeds the total thresholds mentioned above could face the 40% IHT charge. This can include:

Cash savings
Investments, such as those held in ISAs
Property and any other asset of value.

It’s worth remembering that pensions generally don’t count towards the value of your estate for IHT purposes.

Trusts could help you mitigate a large IHT bill

If you believe the value of your estate will exceed the nil-rate bands, it’s wise to mitigate any IHT burden long before you pass away. One of the ways to potentially do this is through a trust.

Essentially, a trust is a type of legal agreement that moves assets out of your ownership and places them in a legal framework that your nominated trustees – the individuals you appoint to oversee it (which can include yourself) – manage under the terms of the deed. In essence, it ensures that the right money can be passed to the right people, at the right time.

As the settlor (creator of the trust), you can also act as a Trustee. Depending on the type of trust, you may then be able to decide who receives what, and when they receive it. For instance, you may ensure that the beneficiary can only access your ringfenced money or assets when they reach the age of 18 and become financially independent.

Normally, any assets you place in a trust fall outside of your estate, provided that you survive for seven years after placing them there. However, it’s vital to note that depending on the type of trust being used, you may have to pay:

20% IHT on any wealth that exceeds the nil-rate bands when you initially place it into the trust.
A maximum of 6% IHT on any wealth that exceeds the nil-rate bands on the 10-year anniversary of setting up the trust.
A maximum of 6% IHT on any wealth exceeding the nil-rate bands when withdrawn from the trust.

Income generated within the trust may be taxable at higher trust tax rates than if directly in the hands of the individual and tax-free allowances available to the trust may be lower than those available to an individual.

While several stipulations would mean your beneficiaries end up paying IHT on your wealth, a trust could mean that they pay less than the standard IHT rate of 40%. Moreover, you could reduce the size of your estate for IHT purposes, limiting the bill your loved ones could face on the remaining value.

The right trust for you will depend entirely on your needs and personal circumstances, so it’s always wise to seek advice, if you’re not sure which would best suit your needs.

The benefits of using trusts for IHT planning

Now that you know how trusts work and how they could potentially help your loved ones mitigate an IHT bill, there are some essential benefits and downsides to consider.

Advantages of using a trust include:

Your family may pay less Inheritance Tax

Perhaps the main benefit of using trusts for succession planning is that you could reduce the size of your estate for IHT purposes if used successfully.

For instance, you could use a discretionary trust to leave assets up to the value of the nil-rate band. This would then start the “seven-year clock”, the period in which any assets gifted to loved ones fall outside of your estate and aren’t subject to IHT.

Then, when the seven years have passed, the assets left in the trust will fall outside of the value of your estate.

What’s more, your loved ones could pay a reduced rate of IHT on any wealth within the trust that exceeds the nil-rate bands. This could ultimately mean that your family can retain more of your wealth after you pass away, helping them secure their financial future.

You have control over how your estate is managed

As well as reducing the size of your estate, a trust can give you posthumous control over how your wealth is managed.

For example, you can stipulate that your beneficiary can only access the money in the trust once they reach a certain age, and only when they achieve financial independence. This could give you much-needed peace of mind that your loved ones will use the money to better their financial situation and not just waste it on frivolous purchases when they’re younger.

Additionally, a trust can allow you to dictate who gets your wealth. This could be especially useful if there are individuals, such as ex-spouses or stepchildren, who believe they have a claim to your wealth, as you can make sure that your money goes to your intended beneficiaries no matter what happens to you.

The downsides of trusts for IHT planning

There are also some crucial downsides you should keep in mind before placing any wealth in a trust for your loved ones. These include:

Your family could still pay some Inheritance Tax

While trusts can help your loved ones potentially avoid paying tax on your estate after you pass away, it’s important to remember that they aren’t completely “tax-free”.

For instance, if you do not survive for seven years after setting up the trust, the assets ringfenced by it typically don’t fall outside your estate and the normal 40% IHT rate could be applied.

You could also still end up paying some IHT on any wealth that exceeds the nil-rate bands when you set up the trust. As mentioned, this could be every 10 years after setting it up, or after assets exit the trust.

Trusts can be overly complex

There are several distinct types of trust, each suiting certain situations, and the rules surrounding IHT mitigation tend to get complicated.

Deciphering what you, your trustees, and beneficiaries could owe, and the type of tax liable, can be a complex process. If you make mistakes when you set up a trust, or use one that isn’t suitable for your circumstances, your family could end up paying more IHT than expected when you pass away, which could ultimately affect their standard of living.

Thankfully, working with a financial adviser could help you avoid making any errors with trusts. Your Flying Colours financial adviser could talk through any tax implications when you set up a trust, and discuss any ways to mitigate a bill wherever possible.

Moreover, we can help you understand both the benefits and downsides of placing funds in trusts for your loved ones, and highlight any other ways you could effectively mitigate IHT.