Neil MacLeod: Beat the freeze - IHT planning using trusts

The Chancellor announced that both the nil and residence nil rate bands are frozen until April 2026. The nil-rate band (NRB) will continue at £325,000, the residence nil-rate band (RNRB) will remain at £175,000, and the RNRB taper threshold continues at £2m.

Therefore a single person maximising the nil rate bands, can pass on up to £500,000 with no inheritance tax (IHT) liability.  A married couple or those in a civil partnership can pass on up to £1m with no IHT.

This poses some interesting questions for those who have or, are on the cusp of having, an IHT liability. Even a modest increase in an estate valued at £1m could result in significant additional tax being payable.

One way of dealing with this problem is by making use of trusts. Different trusts have different access for the settlor, with differing IHT effectiveness. Regardless of the trust type all growth is outside the estate.

Gift Trust

• For clients who want to make a gift to reduce the size of their estate
• The settlor has no access to the gifted capital 

The gift is either a potentially exempt transfer (PET) or chargeable lifetime transfer (CLT) depending on whether the trust is discretionary or absolute and takes seven years to fall out of the settlor's estate

Discounted Gift Trust

• Discounted gift trusts (DGT) are for clients who want to gift capital into trust but receive regular capital payments.
• The settlor decides at outset what withdrawals they want from the trust. With most DGTs this involves agreeing a fixed withdrawal that will be paid for the settlor's lifetime.
• The settlor has no access to the gifted capital.  
• As the settlor has retained a right to withdrawals the value of the gift is discounted. The value of the gift is either a PET or CLT and will take seven years to fall out of the estate.
• It is important that repayments are required i.e. there is no other source of income. And they are spent i.e. do not accumulate in the estate.

Loan Trust

• The settlors lend money to the trustees, who invest it
• The outstanding loan is repayable on demand and is an asset of the settlor's estate
• As there is no gift being made there is no PET or CLT.

A case study

Mrs Johnson is 69 and widowed. She meets with her financial adviser to discuss IHT. During their discussions, they summarise her assets to establish her wealth.

House                                                £550,000

ISAs                                                    £225,000

Cash                                                   £150,000

Investments                                    £325,000

Total Value of Assets                   £1,250,000

Mrs Johnson has two NRBs and RNRBs as when her husband died, all assets passed to her. With £1m IHT free her current liability is £100,000.  

Her late husband's pension scheme and state pension provide her with a regular income. Despite this, she still resorts to spending her savings to supplement her income. Having looked at her outgoings they agree she requires an additional £15,000 p.a. to maintain her current lifestyle. 

After further discussion, Mrs Johnson confirms she would be open to suggestions to do something with £325,000 to mitigate the IHT on her estate. She doesn't want to make outright gifts to her children as she says they should make their own way in the world and worries that the money will be squandered. She has a cautious attitude to risk so her adviser rules out business relief as an option.

Her adviser goes away to consider possible trust recommendations and compares the impact of using a gift trust, discounted gift trust or a loan trust on her IHT position.

His assumptions are based on all non-cash assets growing at 4% p.a., cash growing at 1% p.a. and the nil rate bands remaining at the same level.

After investigation, based on her age and withdrawals of £15,000 p.a. it is calculated that the DGT would potentially receive a 56.1% discount meaning the chargeable transfer would be reduced to £142,650.

The adviser realises that doing nothing is not an option. Spending £15,000 a year from her capital is sustainable but her estate's still growing and so increasing her IHT liability.

The loan trust will have more of an impact as the growth accrues outside the estate. Taking loan repayments of £15,000 p.a. means that the loan would be repaid after just over 21 years. This meets her ‘income' need and is more IHT efficient than doing nothing. It also leaves her non-trust assets growing inside her estate.

The DGT provides the biggest IHT saving in the first seven years, however from that point onwards the IHT will increase because the withdrawals are being provided from the trust and her estate continues to grow.  DGT gives the biggest initial saving because of the discount.

However, her life expectancy is greater than seven years. She has other assets to support her income so the DGT repayments are just increasing her estate. The average life expectancy for a 69-year-old woman in good health is 88.

With saving IHT a primary objective and Mrs Johnson expected to live beyond seven years, the adviser recommends Mrs Johnson sets up a gift trust and covers the income requirement from her non-trust assets.

Neil MacLeod is technical manager at Prudential UK