When you’re developing a financial plan, you typically start by thinking about the goals you want to achieve with your wealth. Funding your dream retirement is likely one of your main aims, but you may also consider how you could support your loved ones.
That’s why it’s important to plan how you will pass wealth to your family when you are gone. Finding ways to mitigate certain taxes, especially Inheritance Tax (IHT), could help your loved ones retain more of your estate when you die.
Fortunately, there are several ways to do this, including trusts.
A trust allows you to give a third-party – the “trustee” – the right to hold assets for the benefit of another person or people – the “beneficiaries”. You no longer formally own the assets, but you can set out conditions about their treatment that the trustee must follow.
Trusts can be an effective way to ensure that wealth is passed on according to your wishes. In some cases, they may also help you mitigate tax.
However, there’s a lot of confusion about trusts and you may easily misunderstand how they work and when you could benefit from using them, particularly when it comes to tax.
Here are three common myths about tax and trusts, and why they are not true.
1. Trusts are only useful for extremely wealthy people
Some people believe that trusts are only useful for extremely wealthy people whose families are likely to pay a large amount of IHT.
This isn’t necessarily true because the number of people affected by IHT is on the rise.
In the 2023/24 tax year, you can pass on £325,000 without IHT. This is your “nil-rate band”. You also have an additional £175,000 “residence nil-rate band” if a direct descendant such as a child or grandchild inherits your main residence.
Further to this, your spouse can inherit your entire estate without IHT and can also benefit from your unused nil-rate bands. As a result, you may be able to pass on up to £1 million between you.
That said, the nil-rate band has been frozen since 2009 and will remain so until at least 2028. Meanwhile, the value of your estate could go up.
The residence nil-rate band has increased several times, reaching its current level of £175,000 in 2020. Yet, this is still less than the average UK house price.
According to the Office for National Statistics (ONS), the average UK house price was £285,000 in December 2023 and, depending on where you live and the size of the property, yours could be worth far more than this.
Additionally, you may see growth on your savings and investments over time. As a result, more of your estate could exceed the frozen nil-rate bands and your family may be more likely to pay IHT than you think.
Also, bear in mind that trusts aren’t only useful for mitigating tax. They could also give you more control over how your estate is managed when you die.
For example, if you have a blended family, you might want to use trusts to ensure that children from a previous marriage also inherit a portion of your estate.
As such, trusts can be a beneficial estate planning tool for many people, not just the extremely wealthy.
2. Your beneficiaries won’t pay any tax at all if you use a trust
Another common myth is that your beneficiaries won’t pay any tax on your estate at all if you place assets in a trust.
Unfortunately, this isn’t the case – your family could still pay some IHT on the estate. However, using a trust may reduce the amount that they pay.
When you put assets in a trust, you are subject to the normal IHT gifting rules. This means that the first £3,000 you gift automatically falls outside your estate for IHT purposes.
Any further gifts fall outside your estate provided you survive for seven years after giving the gift. If you die before this, the wealth will normally be considered in any IHT calculations.
However, there are additional rules to consider when placing assets in a trust.
First, the trust is typically valued 10 years after it is set up, and every 10 years after that. After these valuations, a 6% IHT charge may be applied to any wealth that exceeds your nil-rate bands.
Additionally, when you die, your family may pay 20% IHT on any assets in a trust that exceed your nil-rate bands.
So, even though your family likely pays less than the standard rate of 40%, and trusts can be an effective tax planning tool, they don’t eliminate IHT altogether.
Your beneficiaries might also pay Income Tax when taking an income from assets in a trust.
3. You don’t need a trust if you have a will
A will is a crucial estate planning tool that outlines how you want your assets to be distributed when you die. Without one, your assets may be inherited by people that you didn’t intend, and your family could face difficulties administering the estate.
Writing a will can also help mitigate IHT in several ways. For example, you can ensure that a spouse inherits your full estate and doesn’t pay IHT on it. You can also specify that a direct descendant inherits your main residence, so they benefit from the full residence nil-rate band.
Additionally, you might decide to leave gifts to charity in your will. Any wealth you gift to charity falls outside your estate for IHT purposes and if you leave at least 10% of your taxable estate – the portion that exceeds your nil-rate bands – your family pays IHT at a reduced rate of 36% instead of 40%.
As a result, some people believe that they don’t need to use a trust if they have a will in place because they are already taking steps to mitigate IHT.
However, a trust offers more potential tax planning benefits, as through a trust your family may pay only 20% instead of 40% IHT on your taxable estate.
As such, it could be effective to use trusts alongside your will to ensure you are being as tax-efficient as possible.
The rules around trusts are complicated and the exact amount of IHT and Income Tax your family may be liable to pay often depends on the type of trust you use, and the assets you place in it.
To help you understand more about how trusts may be beneficial for you and your family, it may be useful to seek professional guidance.
A professional financial planner can assist in setting up trusts correctly, while ensuring that you understand the rules and are being as tax-efficient as possible.
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Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
The Financial Conduct Authority does not regulate estate planning, tax planning, or will writing.