Hargreaves Lansdown’s Sarah Coles explains the role of trusts in estate planning and minimising Inheritance Tax.
Trusts and dogs
In many ways, trusts are like dogs. We see rare and exotic breeds in the hands of the idle offspring of footballers and celebrities, but we don’t have a clue what they are, or what they’re for, and we fully expect to get through life without ever coming into contact with one.
However, just like with dogs, trusts come in endless varieties, so while we might not see the point of an enormously expensive one that’s ridiculously difficult to maintain, other more common varieties can be very useful, straightforward, and free to run.
Trusts are relatively simple creatures at heart. You want to give something away, and for someone else to benefit from it. However, for one reason or another, you don’t want to hand it over to them immediately – so you put it in a trust. The trust is then run for their benefit.
Who is involved
There are three important people (or groups of people) relating to every trust. The first is the person who hands over the money or assets in the first place (known as a settlor): once they’ve put the money into the trust, they no longer own any of it.
The second is the person (or people) who look after money in the trust (known as trustees). They legally own everything in there, but they have a responsibility to use it purely in the interests of the third group – the beneficiary or beneficiaries, who at some point will benefit from everything in the trust.
Why use trusts?
It begs the question of why you wouldn’t just hand over the gift to the person who you want to benefit, and there are a few reasons for this.
The first is to do with control. You might want to use the trust to ensure a beneficiary doesn’t have control when it’s not appropriate – perhaps they are too young or you’re not sure how they would handle large sums of money.
You may also want to ensure money in the trust is handled as you want after your death. If, for example, you and your partner both have children within other relationships before you met, you might want to leave your estate so that it benefits your partner during their lifetime, but protects the interests of your own children too. It means, for example, that if your partner remarries, the money cannot pass to their new family.
And the other reason for setting up a trust is Inheritance Tax, because essentially when you put the money into the trust, you are giving it away.
This means that after seven years it is counted as being out of your estate for Inheritance Tax purposes. In some cases, it’s that straightforward: in others, in return for saving this tax you’ll take on a bucket load of complexity and a number of other taxes.
Straightforward and simple
The most common kind of trust, the bare trust, is very straightforward. It’s used, among other things, for investing for children under the age of 18.
You appoint trustees (of which you may be one) and transfer money to the trust. The trustees then manage the investments and have the power to use it however they see fit – as long as it is in the interests of the beneficiary. It automatically passes to the child when they reach the age of 18.
The major benefit of this kind of trust is that you can pass on your assets without actually giving control of them to the beneficiary until they are older.
This is such an established way to invest for children that most fund management companies and investment services firms have very simple forms you can use to set up a bare trust, and don’t charge any extra for this process.
It has tax benefits too, because once cash is transferred to the trust it counts as leaving your estate, so it is taxed as belonging to the beneficiary. If they are a child, in most cases it means there’s no tax to pay. If they are an adult they will pay tax at their own marginal rate.
The tax-free exception for children is where the trust has been set up by a parent and income generated by savings or investments in the trust busts the £100 limit (per parent), in which case it taxed as belonging to the parent. It makes this a more suitable way for wider family members to invest for children – such as grandparents. If parents set this up, it makes sense to focus on growth investments, so any income remains below £100.
Junior ISAs and life insurance
It’s also important to consider the Junior ISA as an alternative, because it is tied up until your child turns 18, and free of tax regardless of who contributes to it. There’s an annual limit (which this year is £4,260), but if you’re planning to give away sums below this level, it may be ideal.
Another free and easy trust is writing a life insurance policy in trust – which costs no more than taking the policy out itself.
If the policy is in trust, when you die, rather than the proceeds going into your estate, they go straight to the beneficiaries. This means that there’s no risk that the proceeds will be subject to Inheritance Tax. It also means the beneficiaries don’t have to wait for probate, because they get the cash straight away.
There’s also a trust that may well be in your life already that you have no idea about, because many workplace pensions are written in trust. This isn’t going to affect you on a day-to-day basis, but it will make a difference after you die. In order to make sure trustees pay any death benefits or untouched pension pot to the right person, you need to complete a nomination of beneficiaries form.
Unfortunately, not all trusts are so simple. Despite the fact that all trusts have the same basic structure of settlor, trustee and beneficiary, there’s an endless number of variations you can opt for – which is where the complexity comes in.
Take the beneficiaries, for example. You might set up a trust for a specific individual, but then what happens if they die? Alternatively, you might set it up for a group of people – like all your grandchildren – but then what happens if another one is born? Confusingly, they may not all benefit at the same time.
So, for example, a trust could benefit your widow during their lifetime, and then pass to your children. Finally, you can give the trustee discretion to choose which beneficiaries to pay.
Once you deviate from a straightforward trust, it’s going to take time and money to run it. In some cases, there’s a heap of administration when money is put into the trust and taken out of it, plus a heap more involved in running the trust. Trustees, for example, may need to complete a tax return and pay income tax for the trust.
The tax itself can be onerous as well as complicated. In some trusts, you pay tax when you put money in, tax at the top rate as you go along, and then tax when the assets are passed on. And to make matters worse, it’s monumentally complicated too, because there are exceptions and variations to each of these things depending on the circumstances and the type of trust.
As a general rule of thumb, it is only likely to be worth considering a complex bespoke trust for tax purposes if you are handing over at least £50,000.
It’s worth getting to grips with trusts and thinking carefully whether there might be space for the right kind of trust in your finances. Because while a rare and expensive breed might not be the answer, there are plenty of everyday trusts whose bark is worse than their bite.
Sarah Coles is a personal finance analyst at Hargreaves Lansdown and a frequent contributor to loveMONEY. The views in this article do not necessarily reflect those of loveMONEY.
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