A Discounted Gift Trust lets you make a gift for inheritance tax reasons while still being able to receive a fixed income, such as regular withdrawals, for your lifetime or until the trust runs out.
First, determine the exact amount of income you need based on the amount of capital you plan to gift. Once established, you can’t change the income level unless you follow these pre-set increases, as changing it later could affect the effectiveness of the IHT planning. Based on your age and state of health, the insurance company will place a value on this income using actuarial tables. An investment bond is often used to hold a lump sum because it allows for regular withdrawals without immediate taxes. A trust is then created to gift the remaining money that isn’t needed for your income to your beneficiaries. You can choose either a flexible or an absolute trust, which are explained below.
Flexible trust
A flexible trust is created for your beneficiaries using your money. For inheritance tax purposes, you will transfer a certain amount into the trust, but this amount is reduced by the value of any regular income payments you want to keep. This is because the tax calculation considers only the amount that reduces your estate. The income you retain remains yours and is not included in the gift. A flexible trust provides more options than an absolute trust. You can adjust the amount each beneficiary receives, remove existing beneficiaries, or add new ones. Every ten years, a tax charge may be applied to the trust. This occurs only if the trust’s value (minus the discount) exceeds the nil-rate band, which is currently £325,000 and remains frozen until 2030.
While your estate will be reduced by the full investment amount, the Chargeable Transfer when establishing the trust will be decreased by the discount and any available exemptions. Any part of the Chargeable Transfer exceeding the nil-rate band will be taxed at the current inheritance tax rate of 20%. If your total chargeable transfers in the previous seven years, including this one, stay below the nil-rate band, no inheritance tax will be due.
Should you die within seven years of creating this scheme, the discounted transfer will be considered part of your estate at the time of death, and your estate will receive a ‘credit’ for any tax paid during setup.
Once operational, the trust becomes a separate entity for inheritance tax purposes, and additional tax charges could occur. However, if no tax was payable when establishing the scheme, it is unlikely that these charges will apply, since they depend on future growth within the trust, though no guarantees are offered. The current maximum tax rate on the charge is 6% of any amount exceeding the nil-rate band. The trust’s value will be determined by the bond’s value minus the discount, calculated based on your age at that time. This discount will decrease at each periodic charge date.
The second charge will occur when money, excluding regular payments made to you, leaves the trust. The applicable rate of tax will depend on whether tax was paid during scheme setup or at the ten-year anniversary prior to the payment. A maximum rate of 6% applies, but if no tax was paid at either point, no tax will be charged upon exit.
Absolute trust
This trust is created with a specific amount of money for your beneficiaries. When transferring this money, for inheritance tax purposes, it’s considered as your potentially exempt gift, minus any regular payments you want to keep for your income. This means the transfer reduces the value of your estate for inheritance tax. The regular payments you keep are considered your income and are not included in this calculation. When you pass away, this income stops, and although it’s still part of your estate, it doesn’t affect inheritance tax. The ‘discount’ comes from this arrangement.
This trust cannot be changed once set up. If a beneficiary dies before receiving their share, that share will pass according to their will or, if there is no will, under the laws of intestacy. Y
our estate will be reduced by the full amount of the investment, but a Potentially Exempt Transfer (PET) amount will be calculated as the discounted value, minus any available exemptions. PETs are considered exempt transfers when made, and if you survive for 7 years after the transfer, it becomes fully exempt from inheritance tax. If you die within 7 years, the transfer may be taxed. If taxed, it will be added back to your estate, based on the lower of the asset’s value at the time of transfer or at your death. The tax rate will be the lower of the rates in effect at the time of transfer or at death.
If the value of the PET (Potentially Exempt Transfer) goes over the Inheritance Tax nil rate band, there might be inheritance tax to pay on the recipients of the gift, such as trust beneficiaries. If you survive at least 3 years but less than 7 years after making the gift, the tax liability is reduced through a sliding scale called Taper Relief.
Discount
Entering into this arrangement (assuming the ‘income’ valuation is not challenged by the Revenue) will immediately reduce your estate for inheritance tax purposes by the amount of income you expect to receive during the plan’s duration. The remaining gift will then fall outside your estate after 7 years. The value is subject to agreement by HM Revenue & Customs and is based on actuarial assumptions that you are in good health for your age. While HM Revenue & Customs may accept the general calculation method, each case can be negotiated individually. The figures are only guides, and there’s no guarantee they will be accepted, especially if a claim is made early in the plan.
Risk considerations
There are some risks you should know about. Past performance doesn’t guarantee future results. If the fund doesn’t grow much, fees might reduce your invested capital. The value of your units can go up or down, and you might not get back the full amount you invested when you cash out. Early withdrawals could have penalties. If you withdraw more than the fund’s growth, you might lose some of your initial capital. HM Revenue and Customs might not approve the discounted value used for calculations.
Regular withdrawals will become part of your estate and won’t benefit from inheritance tax advantages unless spent. If you gift the money instead of spending it, it will be subject to gifting rules and stay in your estate for 7 years.
When you transfer your capital to the trust, you won’t have access to it after that, except for income. Some individual funds might be riskier than your overall risk level, but the overall risk is set to match your comfort level.
