Useful solutions

Margaret Jago discusses the use of discounted gift trusts in inheritance tax planning

Clients often have conflicting financial planning aims when approaching retirement. Many can have large sums to invest, from downsizing the main home or tax-free lump sums taken from pensions, so planning is often required to generate sufficient income for a comfortable retirement.

At the same time, those making any investment may be worried about the eventual inheritance tax (IHT) bill on their capital. A tax bill at 40% on all assets above the IHT threshold can feel like a high price to pay where savings have been built up carefully over a lifetime.

For clients with the apparently conflicting aims of investing for income and of mitigating IHT, we have found that a discounted gift trust can provide a useful solution. As well as providing income, the fact that the trust is drafted to specifically restrict access means that these arrangements are effective for IHT purposes.

What is a discounted gift trust? 

In their simplest form, these are trusts where an individual can make an IHT effective gift and retain rights to an income.

This is perhaps best illustrated by an example. A client has £100,000 which they could transfer to a trust to reduce their potential IHT exposure, however they need the £5,000 income this generates each year to supplement their retirement income. With a discounted gift trust they can achieve their IHT planning and, by retaining a right to 5% of the amount gifted, can also benefit from £5,000 each year while there is money within the trust. Only on the death of the client will the chosen beneficiaries benefit from the trust fund.

The IHT treatment depends on which type of trust you chose, but is no different from the usual tax rules.

With a bare trust, there is no immediate tax to pay at the date of the gift. If your client was to die within seven years the gift becomes chargeable to IHT and the tax due depends on the client’s IHT history and overall circumstances. If the client survives past the end of the seven year period the gift is exempt from IHT.

A discretionary trust can provide more flexibility, at the cost of a more complex IHT treatment. The usual tax rules still apply with the gift being immediately chargeable to IHT, but if your client doesn’t exceed their IHT nil rate band no tax will be due.

However, with discretionary trusts the ongoing IHT treatment can be complex. Whichever type of trust is used, this planning can reduce your client’s overall IHT liability even if they don’t survive for seven years as the actual loss to your client’s estate is reduced by the value of the retained rights, known as the discount.

Discounted gift trusts can be set up using different types of assets but the tax treatment and administrative simplicity of bonds mean they are often chosen.

Advantages

There are two main tax advantages. Firstly, the chargeable event rules allow tax deferred annual bond withdrawals of 5% of premium to be taken for 20 years, which is very helpful in funding repayments from the trust. Secondly, bonds gains are not usually taxed on the trustees. The eventual tax liabilities will fall on the settlor or on the beneficiaries. This is particularly useful given that the income tax rate for trustees is set to rise to 50% in 2010-11 (42.5% for taxed dividend income).

In deciding whether to go ahead with an arrangement like a discounted gift trust clients may be concerned about how IHT is likely to change in the current economic environment.  Discounted gift trusts have been an accepted form of tax planning for a number of years with HM Revenue & Customs providing guidance in 2007, and although some anti avoidance measures were put in place in the 2009 Pre Budget Report (PBR), clients can be reassured that these do not affect the planning described here.

Should Labour or a Labour/LibDem coalition be elected it is likely that planning will continue to become more difficult as further measures are put in place to deal with the current deficit. Clients worried about this will want to take action sooner rather than later. Clients confident that we will have a Conservative government may feel less inclined to mitigate IHT except where wealth levels are very high – however as we have seen in the past, it can be very difficult to predict the future and it is certainly worth discussing this with clients at financial year end planning meetings.

Margaret Jago is manager investment products, tax and regulation at Aegon