The Quiet Power of Trusts: Your Best Defence Against Inheritance Tax?
- Chris Young
- Oct 9
- 8 min read
Inheritance tax (IHT) can substantially reduce the value of assets passed to your beneficiaries. Setting up a trust is a proven strategy to mitigate IHT liabilities while maintaining control over how your wealth is distributed. This guide explains how trusts work, their advantages in estate planning, and actionable strategies to optimise tax efficiency.
What is a Trust and How Does it Work?
Definition of a Trust
A trust is a legal arrangement where a settlor transfers assets to trustees, who manage them for the benefit of named beneficiaries. Trusts create a separate legal entity, allowing for control, protection, and tax efficiency. They can be used to structure wealth effectively, manage inheritance tax liabilities, and provide long-term financial stability for beneficiaries.
Key participants in a trust include:
The Settlor: The person who creates the trust and contributes assets. The settlor establishes the terms of the trust, such as how and when assets are distributed.
The Trustee: Individuals or organisations responsible for managing the trust. Trustees have a fiduciary duty to act in the best interests of the beneficiaries and ensure the trust operates as intended.
The Beneficiary: The people or entities who benefit from the trust assets. Beneficiaries can receive income, capital, or other benefits as outlined in the trust deed. Trusts can protect these assets from creditors, divorce settlements, and other potential risks.
By clearly defining roles and responsibilities, trusts offer flexibility and control over asset distribution, making them an essential tool in estate and tax planning.
Types of Trust
Common types of trusts used in IHT planning include:
Discretionary Trusts: Offer flexibility by allowing trustees to decide how and when to distribute assets, taking into account the beneficiaries’ circumstances and needs. This flexibility is particularly beneficial for families with changing dynamics or long-term planning requirements. Trustees can also withhold distributions if they deem it beneficial.
Bare Trusts: Assets are held for specific beneficiaries who gain absolute ownership at a certain age, typically 18 or 21. These trusts are straightforward and often used for children or young adults to ensure funds are available for education, property purchases, or other significant milestones.
Life Interest Trusts: Provide income to one beneficiary while preserving the capital for others. For instance, a surviving spouse may receive income during their lifetime, ensuring their financial security, while the remaining capital is preserved for children or other beneficiaries. These trusts are ideal for blended families or multi-generational planning, balancing the interests of different parties.
Each type of trust serves distinct purposes and requires careful consideration to align with financial goals and family needs.
How Can I use a Trust to Mitigate Inheritance Tax?
Using trusts can help reduce inheritance tax (IHT) by transferring assets out of your estate into the ownership of trustees, meaning these assets are no longer included when valuing your estate for IHT purposes. Transfers into a bare trust may also be exempt from IHT if the person making the transfer survives for 7 years after the transfer. Trusts are a powerful tool for lowering your taxable estate, safeguarding wealth for future generations, and ensuring tax-efficient distribution of assets.
Example 1: Discounted Gift Trust
A discounted gift trust allows the settlor to make a gift into a trust while retaining the right to receive fixed regular payments (an income stream). The value of the gift is “discounted” for IHT purposes because the settlor retains this benefit.
For example:
If a settlor places £500,000 into a discounted gift trust with a £250,000 discount (representing the actuarial value of the retained income stream), only £250,000 is treated as a gift for IHT purposes.
If the settlor survives seven years, the discounted value (£250,000) is removed from their estate entirely.
The IHT saving would be £250,000 x 40% = £100,000.
This approach reduces the estate’s IHT liability while providing the settlor with ongoing income.
Example 2: Gift and Loan Trust
A gift and loan trust involves the settlor lending a sum of money to a trust rather than gifting it outright. The trust invests the loan, and the growth on the investment accrues outside the settlor’s estate for IHT purposes.
For example:
The settlor loans £1,000,000 to the trust. Over time, the trust invests this sum, and it grows to £1,500,000.
The growth (£500,000) is outside the settlor’s estate, reducing the IHT liability by £500,000 x 40% = £200,000.
The settlor retains the right to recall the original loan amount, often in instalments, while the investment growth remains protected within the trust.
This strategy allows the settlor to maintain access to capital while achieving significant IHT savings.
Limits of Using Trusts to mitigate Inheritance Tax
While trusts provide notable tax advantages, they don’t always eliminate IHT entirely. For instance:
Periodic or Exit Charges: Certain trusts, such as discretionary trusts, may incur periodic charges every 10 years or exit charges when assets are distributed to beneficiaries. These charges ensure that trusts are not used as permanent tax shelters.
Seven-Year Rule: Gifts made into a trust are only exempt from IHT if the settlor survives for at least seven years after the transfer. If the settlor passes away within this period, the gift remains part of their estate for IHT purposes
What is the 7 Year Rule in Trust Planning?
The seven-year rule plays a critical role in IHT planning with trusts. It states that gifts transferred into a trust are exempt from IHT if the settlor lives for seven years following the transfer.
However, tapered relief may apply for gifts made within three to seven years of death, reducing the IHT liability proportionally. This makes early and strategic planning essential to maximise the benefits of using trusts in your estate plan.
How do I se t up a Trust Fund to mitigate Inheritance Tax?
Steps to Create a Trust for Inheritance Tax Planning
Determine Objectives: Identify your goals, such as reducing IHT or protecting assets for specific beneficiaries.
Choose the Trust Type: Select the appropriate trust based on your needs.
Appoint Trustees: Assign reliable individuals or professionals to manage the trust.
Transfer Assets: Legally transfer ownership of assets to the trust.
Establish Legal Documentation: Draft and sign a trust deed with the help of a solicitor.
How much does it cost to set up a trust?
Setting up a trust involves costs such as:
Legal Fees: Drafting the trust deed and obtaining legal advice.
Ongoing Administration: Annual management fees and potential tax charges.
Advantages and Disadvantages of Using Trusts
Advantages
Trusts offer a range of benefits that make them a valuable tool in inheritance tax planning. They not only reduce inheritance tax liabilities but also provide control and protection over your assets. Below are the key advantages to consider:
Tax Efficiency: Trusts remove assets from the taxable estate, reducing the IHT liability.
Control: Trusts allow the settlor to determine how and when beneficiaries receive assets.
Asset Protection: Safeguard assets from potential risks such as creditors, divorce, or poor financial management by beneficiaries.
These advantages highlight why trusts are an essential part of many estate planning strategies, particularly for those seeking long-term asset security and tax efficiency.
Disadvantages
While trusts provide significant benefits, there are also challenges and costs associated with their use. These downsides must be carefully weighed against the potential advantages to make an informed decision. Below are the main disadvantages to be aware of:
Setup Costs: Trusts require legal expertise, which can be expensive.
Ongoing Administration: Trustees must manage the trust carefully, adhering to legal and tax obligations.
Complexity: Trusts involve intricate rules and may require professional guidance to operate effectively.
These disadvantages underscore the importance of seeking expert advice when setting up a trust to ensure compliance with legal requirements and alignment with your financial goals.
Combining Trusts with Life Insurance
A common strategy is to pair a trust with a life insurance policy to cover IHT liabilities. This ensures that beneficiaries inherit the estate intact without needing to sell valuable assets, such as a family home or business.
Example: A life insurance policy worth £1,000,000 is placed into a trust. Upon the settlor’s death, the policy pays out directly to the trust, covering an estate’s IHT liability. This approach secures the inheritance of high-value assets like a £2,500,000 family home, which might otherwise need to be sold to cover the £1,000,000 IHT bill.
Key Considerations When Using Trusts as a best Defence against Inheritance Tax
Choosing the Right Kind of Trust
Selecting the most suitable type of trust is critical to achieving your financial goals. Different trust structures serve various purposes, such as mitigating inheritance tax, protecting assets from creditors, or providing for minor or vulnerable beneficiaries. Key factors to consider include:
The nature and value of the assets being placed in trust.
Your long-term financial and estate planning objectives.
The needs and circumstances of your beneficiaries.
Professional advice is essential to ensure the chosen trust type aligns with your goals and complies with legal requirements.
Appointing Trustees and Their Responsibilities
Trustees are the stewards of the trust and bear significant legal and ethical responsibilities. When appointing trustees, consider:
Skills and Expertise: Choose individuals with strong financial literacy and a clear understanding of their fiduciary duties.
Integrity and Trustworthiness: Trustees must act in the beneficiaries’ best interests, making impartial and prudent decisions.
Capacity and Availability: Ensure trustees have the time and capacity to fulfil their responsibilities, which may include managing investments, filing tax returns, and distributing assets.
It’s often beneficial to appoint a mix of family members and professionals, such as solicitors or financial advisers, to balance personal understanding with professional expertise.
Reviewing and Updating your Trust Plan
Trusts are not a “set-it-and-forget-it” solution. Changes in personal circumstances, family dynamics, or trust laws can impact their effectiveness. Regular reviews are crucial to:
Ensure the trust complies with current regulations and tax laws.
Adapt the trust structure to reflect changes in your financial situation or family needs.
Update trustees or beneficiaries as necessary.
Confirm that the trust continues to align with your overarching estate and financial planning goals.
By scheduling periodic reviews with a financial adviser or legal professional, you can ensure your trust remains a valuable tool in protecting and managing your assets.
Conclusion: Plan Early, Act Strategically
So, is using trusts one of the best defences against Inheritance Tax? Inheritance Tax is not just about numbers — it’s about legacy, family, and control. With the upcoming reforms to reliefs and a continued freeze on allowances, now is the time to review your estate plan.
Whether you're passing on a business, farm, property, or simply building up your savings, the right strategy can make a six-figure difference.
Next Steps: Take Control of Your Estate Planning
>>>> Book a free, no-obligation retirement planning consultation to map out a plan that suits you, your family, and your goals.
Financial Adviser Cheshire and Pension Adviser Chester
XV Wealth are an Independent Financial Adviser based in Chester, Cheshire.
About us: XV Wealth is an independent financial advisor based in Chester. As independent financial advisers, we can provide independent and unbiased financial advice. We provide independent financial advice, pension advice,investment advice, inheritance tax planning and insurance advice. If you want to speak to a Financial Advisor, we offer an Initial Financial Consultation without cost or commitment. Meetings are held either at our offices, by video or by telephone. Our telephone number is 01244 62 88 71. XV Wealth Financial Advisers email is info@xvwealth.co.uk.
This article is for information purposes and does not constitute financial advice, which should be based on your individual circumstances.
The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Past performance is not a guide to what might happen in the future.
The value of pensions and any income from them can fall as well as rise. You may not get back the full amount invested.
Levels and bases of, and reliefs from, taxation are subject to change and their value will depend upon personal circumstances. Taxation and pension legislation may change in the future.