Trusts can be a tax-efficient way to set funds aside for loved ones. Here are 3 tax factors to consider when ring-fencing wealth within a trust.
Trusts are often considered one of the best ways to pass funds tax-efficiently to those you love.
Indeed, placing wealth in a trust can allow you to have greater control over funds that are passed down, and is often considered a crucial part of the estate planning process.
By passing on your wealth in the form of a trust, you can:
- Potentially mitigate Inheritance Tax (IHT) – something you’ll read about later in this article
- Specify when the funds can be made available, and to who
- Ensure the wealth is used as you’ve intended, even after you’ve passed away
- Allow your loved ones to benefit from your wealth in a time frame that suits everyone.
In addition, there are several types of trust you could use to ringfence funds for your loved ones. Here are five of the most common types of trust:
1. Bare trust
2. Discretionary trust
3. Accumulation trust
4. Interest in possession trust
5. Mixed trust
These all have slightly different ways of operating and may carry varied tax implications. Across the board, though, there is one prevalent myth that surrounds trusts: that they are a “tax-free” way to pass money to others.
In fact, while ringfencing wealth within a trust can reduce the tax liability that may be incurred, there are still tax factors you should be aware of before setting up a trust.
Read on to find out three important tax implications that may come with using trusts to pass money to your loved ones.
1. Ringfencing assets within a trust can reduce Inheritance Tax, but it is unlikely to help you avoid it altogether
IHT receipts have soared in recent years, largely due to the government’s freezing of the “nil-rate bands”. These bands limit how much you can pass down to your loved ones when you die, without incurring an IHT bill.
The nil-rate band, applying to all taxable assets, has stood at £325,000 since 2009. The residence nil-rate band, which is applied to property passed to direct descendants, stands at £175,000. Both have been fixed at these rates until 2028.
As a result of these freezes, FTAdviser reports that between April 2022 and January 2023, HMRC took £5.9 billion in IHT – up 15% from the previous year.
So, if your estate appreciates in value while the nil-rate bands remain fixed, your beneficiaries are very likely to pay a larger IHT bill when you pass away.
Fortunately, trusts can help mitigate the IHT your loved ones pay, but this does not mean they are always “IHT-free” as some may believe.
First, the assets within a trust are usually valued on the 10-year anniversary of the trust being set up, and every 10 years after that. Upon valuation, an IHT charge of 6% may be applied to the amount above the nil-rate bands.
What’s more, when you pass away, assets in trust that exceed the nil-rate bands are usually subject to a 20% IHT charge, rather than the usual 40% rate. If you pass away fewer than seven years after establishing the trust you’ve set up for loved ones, the normal 40% rate could be applied.
These rules can vary depending on the type of trust you have, the type of assets you hold within the trust, and for how long you have held the trust. To calculate the IHT due on a trust you hold, or one you may set up in future, contact your Kellands financial planner for a conversation about your unique circumstances.
Ultimately, though, it is important to remember that trusts are not usually “IHT-free”. They can be hugely constructive in reducing IHT, but your beneficiaries should still expect to pay some tax on the funds they receive.
2. Beneficiaries may pay Income Tax when they receive funds from a trust
When the beneficiaries of your trust receive the funds, you should be aware that this wealth is likely to be subject to Income Tax.
Every type of trust has different rules when it comes to the amount at which your beneficiary will begin paying Income Tax, and the rate payable.
In addition, you may be wondering: “who is responsible for paying the Income Tax on a trust?”
This depends on the type of trust you set up. Income Tax on a bare trust, for instance, is payable by the beneficiary, who should contact HMRC directly and complete a self-assessment form.
Conversely, tax on accumulation and discretionary trusts should be taken care of by the trustee – the person in charge of distributing the funds according to the settlor’s wishes. The amount payable depends on how much income is being taken from the trust, among other factors.
In most circumstances, releasing income from a trust will incur an Income Tax bill. It is important for you (the settlor), the trustees, and your beneficiaries to understand how much may be owed, so you can accurately factor trust income into your overall financial plan.
3. Working with a financial planner can help you understand the tax liability incurred by trusts
All in all, the tax you should pay on a trust depends on a number of contributing factors, many of which are unique to you and your circumstances.
These factors include:
- The type of trust you set up
- The value of the assets in the trust
- The type of assets held in the trust
- How long you have held the trust for
- How soon you pass away after setting up the trust
- How much income is drawn from the trust, and by who.
Deciphering what you, your trustees, and your beneficiaries may owe, and the type of tax liable – which can include IHT, Income Tax, Capital Gains Tax (CGT), and Dividend Tax – can be a complex process that may go much more smoothly with the help of a professional.
Your Kellands financial planner can talk through the tax that could be payable on trusts you set up, discuss ways to mitigate these bills where possible, and help you understand both the benefits and drawbacks of placing funds in trust for your loved ones.
Get in touch
If you wish to set up a trust, are receiving money from a trust, or have been appointed as a trustee, we can help you every step of the way. Email us at firstname.lastname@example.org, or call 0161 929 8838.
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
All contents are based on our understanding of HMRC legislation, which is subject to change.