Trust Planning and Inheritance Tax

Reducing your inheritance tax bill isn’t always straightforward, especially when trusts are involved.

One of the trickier areas to understand is how trusts and inheritance tax (IHT) align. But understanding them and then making the most of trusts could benefit you by helping you pass on your wealth efficiently to those you care about most.

Why is that more important than ever?

IHT allowances have been frozen for years now, and while they stay frozen, asset values, particularly property, keep rising. Add to that the fact that from 6 April 2027, most unused pension funds and pension death benefits are due to come within the scope of inheritance tax, subject to specific exclusions.

All this means increasing numbers of families are being pulled into the IHT net, often without realising it until much later than would have been ideal. If you’re not sure what currently sits inside or outside your estate for IHT purposes, our article on exempt assets and inheritance is a good place to start before reading on.

Here we answer what a trust is, the main types of trusts UK families use, how trusts and inheritance tax planning can be part of the same strategy, how the less obvious mechanics like the 10-year charge actually work and how we can help you use IHT trust planning effectively.

What is a trust and why use one for IHT?

A trust is a legal arrangement where one party looks after assets for another party. There are three key roles in the arrangement:

• Settlor – the person who puts assets into the trust
• Trustees – the individuals responsible for managing the trust
• Beneficiaries – those who benefit from the assets held in the trust

In practice, this means that the settlor transfers assets to the trustees, who then manage those assets for the beneficiaries under the rules set out by the settlor.

Trusts can help you reduce your inheritance tax bill, which is becoming more and more pertinent given the UK’s frozen IHT allowances. Planning for inheritance tax and trusts can therefore help you:

• Pass on wealth in a tax-efficient way
• Give long-term support to vulnerable beneficiaries
• Shield family wealth from divorce or bankruptcy
• Manage assets for beneficiaries
• Control the timing and how trust assets are distributed
• Reduce or delay inheritance tax
• Help avoid probate so assets can be accessed more quickly

That last point is worth dwelling on, because it’s often underestimated. Trustees can typically access trust assets on the settlor’s death, without waiting for probate to be granted, which can matter a great deal to a family that needs liquidity quickly while the rest of the estate is still being administered.

It’s also important to understand that the IHT treatment of a trust depends on the type of trust and the circumstances of the transfer. For some gifts into trusts, surviving seven years can be important, while relevant-property trusts can be subject to lifetime, 10-year and exit charges.

Where assets are successfully transferred out of the settlor’s estate for IHT purposes, subsequent growth in those assets can also fall outside the settlor’s estate. The precise treatment, though, depends on the trust structure and also whether the settlor receives any benefit or interest in the assets.

However, what trusts can provide is the ability to have some control over assets. That means, unlike an outright gift, some trust structures allow trustees to retain discretion over when and how beneficiaries receive assets, within the terms of the trust. For many people weighing up whether to gift directly or use a trust, that ongoing control is the deciding factor, not just the tax saving itself.

Given their benefits, it’s vital to use trusts appropriately. When they’re misused, you may leave your heirs liable to unexpected taxes and you’ll not have achieved what you set out to do.

The main trust types used in IHT planning

There are many different types of trust in the UK. Not all will be appropriate for you to use, but with the right structure, you can ensure effective trusts and inheritance tax planning.

A few of these are worth understanding in more depth, since they cover most of what are most commonly used in practice.

Discretionary trusts

The most commonly used type of trust for IHT planning. Trustees have full discretion over who benefits and when, which makes this the most adaptable option for families whose circumstances may change over time.

• A transfer into the trust is a Chargeable Lifetime Transfer (CLT), with an immediate IHT charge of 20% on any amount above the available nil-rate band (£325,000) at the time of transfer
• The trust is subject to a 10-year periodic charge of up to 6% on trust assets above the nil-rate band (more on this below)
• Exit charges apply when assets leave the trust, calculated as a fraction of the 10-year charge based on how many quarters have elapsed since the last 10-year anniversary

Bare trusts

Arguably the simplest trust type. The beneficiary has an immediate and absolute right to both capital and income.

• A transfer into a bare trust is typically a Potentially Exempt Transfer (PET), with no immediate IHT charge
• It becomes fully exempt from IHT if the settlor survives seven years
• There is no 10-year periodic charge
• The trade-off is flexibility: once set up, the beneficiary cannot be changed
• Often used for children, with assets passing to them absolutely at age 18

Interest in possession trusts

Here, a beneficiary is entitled to the income from the trust as it arises, for example rental income or dividends, while the capital passes to other beneficiaries later.

• For assets transferred before 22 March 2006, there is generally no IHT on transfer, but the beneficiary’s interest is treated as part of their own estate on death
• For assets transferred after 22 March 2006, the transfer is treated as a CLT and the 10-year periodic charge applies
• Often used in blended family scenarios, for example income to a surviving spouse for life, with capital passing to children from a first marriage afterwards

Loan trusts

Not shown in the table above, but a structure we’re asked about regularly. Here, the settlor makes an interest-free loan to the trust rather than an outright gift.

• There is no entry IHT charge, because it is a loan rather than a gift
• The loan amount itself remains in the settlor’s estate, but any future growth on the trust assets sits outside the estate
• Repayment of the loan reduces the estate over time as the settlor draws down against it
• Can suit those who want to reduce their IHT exposure but aren’t comfortable making an outright gift, since the loan can be reclaimed if circumstances change
• No seven-year clock applies to the loan itself

Discounted gift trusts

Again, not shown in the table above, this less-used trust is a hybrid structure where the settlor makes a gift to the trust but retains the right to regular fixed withdrawals. The value of the settlor’s retained right to receive payments is then generally treated separately from the value transferred to the trust. Any future IHT treatment depends on the precise terms of the arrangement and the settlor’s circumstances, so specialist advice is essential.

• There is an immediate IHT benefit on creation, as the discounted amount is immediately exempt
• The remainder of the gift follows the usual CLT rules
• Particularly popular with older clients who want IHT planning while retaining some income for themselves

Will trusts

A will trust is created under a person’s will following their death. The IHT treatment depends on the type of trust created and the nature of the assets passing into it. Some will trusts can subsequently be subject to relevant-property charges.

• There is no entry charge in the usual sense, because the assets come from the estate, on which IHT has already been assessed
• The 10-year periodic charge applies to relevant property held in the trust
• Commonly used to hold assets for minor children, vulnerable beneficiaries or in blended family situations

How the 10-year periodic charge works

Above we mention the 10-yearly charge for several trust types, so it’s worth explaining what it actually involves. Every 10 years from the date the trust was set up, HMRC charges IHT on the value of relevant property in the trust. The rate is a maximum of 6% on the value of trust assets above the nil-rate band.

If the full nil-rate band of £325,000 is available and the trust is worth £500,000, the charge is:

(£500,000 minus £325,000) multiplied by 6% = £10,500

This compares favourably with the 40% that would have applied had the assets remained in the settlor’s estate on death.

Worked example: David sets up a discretionary trust in 2026 with £400,000 of investments. By 2036, the 10-year anniversary, the trust has grown to £520,000. Assuming the full nil-rate band is available the 10 year periodic charge is calculated as such:

• The chargeable amount is £520,000 minus £325,000 = £195,000
• The 10-year charge is thus £195,000 multiplied by 6% = £11,700

In this simplified example then, had David died in 2036 with these assets still in his estate, IHT on the same £195,000 excess would have been £78,000 at 40%. The trust structure could therefore save his beneficiaries approximately £66,300 on this one charge alone

Periodic charge calculations can be far more nuanced than this, however. HMRC’s calculations take into account matters including the value of relevant property, the nil-rate band, previous chargeable transfers, related trusts, additions to the settlement. Seek advice to help ensure you make the most appropriate decisions for your situation.

Does that trade-off change how you think about the 10-year charge compared with keeping assets in your own estate?

The 7-year rule and trusts

The seven-year rule applies differently depending on the type of gift or trust. An outright gift to an individual is generally a Potentially Exempt Transfer (PET), while a transfer into a discretionary trust is generally a Chargeable Lifetime Transfer (CLT).

If you gift assets and pass away before seven years is up, some IHT will be due depending on how long it has been since transfer. Taper relief reduces the rate of IHT applied to a gift made within seven years of death. The current bands are:

The seven-year rule matters slightly differently for trusts, though. Transfers into bare trusts are PETs, following the taper above. Transfers into discretionary trusts are CLTs, where the seven-year rule matters for a different reason: it determines whether earlier CLTs erode the nil-rate band available to later ones, under what is known as the 14-year lookback rule. For the full detail on how the seven-year rule and taper relief work, see our dedicated article on the inheritance tax seven-year rule.

The timing of gifting assets underscores why it is crucial to start estate planning as soon as possible.

The key risks

Trusts are powerful, but they aren’t without pitfalls, and this is where professional advice tends to matter most. Here are some of the key risks to bear in mind:

• Gift with reservation of benefit (GWR). If the settlor continues to benefit from assets placed in a trust, for example transferring a property into a trust but continuing to live in it rent-free, HMRC treats the asset as still forming part of the estate. The trust provides no IHT benefit at all in this case
• Pre-owned asset tax (POAT). A related charge that can apply even where a GWR technically doesn’t. If someone has given away an asset and continues to benefit from it indirectly, an annual income tax charge may arise
• Timing of CLTs and previous transfers. If the settlor has made CLTs in the seven years before setting up a new trust, those earlier transfers reduce the nil-rate band available against the new one, potentially triggering a 20% entry charge even on a transfer below £325,000
• Getting the trust type wrong. Using a discretionary trust where a bare trust would have served the purpose, or the other way round, can create unnecessary tax charges or unnecessarily lose flexibility. This is the most common reason to take professional advice before establishing any trust

When might a trust be the right choice?

Trusts tend to be most useful when your estate is clearly above both the nil-rate band and residence nil-rate band thresholds and where gifting outright isn’t appropriate. If you want to make a gift but also retain some control over when and how beneficiaries receive it, trusts can be a good option. They can also be suitable for those that have vulnerable or minor beneficiaries who need assets protected, when liquidity at death matters and bypassing probate has real value to your family, or when your estate includes business or investment assets likely to grow significantly, making it worthwhile to move that growth outside your estate from day one.

They tend to be less useful when your estate is comfortably below the IHT thresholds, when you may need the assets back at some point, or when the administration cost and complexity outweigh the IHT saving on offer. Which of these situations sounds closest to your own?

How our financial advice service can help

If you’d like to explore how trusts could fit into your overall inheritance tax strategy, we’d love to help. We can help you navigate the complexities of trust planning and inheritance tax so your wealth goes where you want it to. Book a free discovery call here.

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