When it comes to passing on wealth to children and grandchildren, the word ‘trust’ comes up a lot.
Trusts are typically seen as the preserve of the wealthy – given to ‘trust fund kids’ who inherit hundreds of thousands of pounds the second they finish their A-levels and disappear on gap years to find themselves – and spend lots of money – on round the world trips.
But trusts are actually used by many very ordinary families too. They are a useful, if rather confusing, way to help keep control of more of your money while passing it on, to minimise certain tax bills, and ensure any life insurance you have is paid out quickly to your surviving family.
Trust funds are typically seen as the preserve of the very wealthy with estates to pass on
But what is a trust, how does it work and is this really the best way to pass on your money to loved ones?
We’ve pulled together what you need to know.
What is a trust?
In essence, a trust is simply a legal structure – a sort of envelope if you like – that allows you (known as the settlor) to ringfence money and appoint someone to manage the trust (known as the trustee, which can be you as well or someone else) and someone to benefit from it (known as the beneficiary).
This has the advantage of allowing you to ensure that children (or adult children or grandchildren) don’t end up having access to thousands of pounds in cash before you’re sure they’re responsible enough to manage it.
Instead, the trustee(s) can choose how money contained in the trust is managed until the beneficiary (your child for example) reaches their 18th birthday.
This has become a major concern for those people looking to give away large sums of money to use the seven-year rule on gifting to avoid inheritance tax.
In the past, trusts were an effective way both to put limitations on children’s access to any early inheritance and to minimise inheritance tax payable by children.
However, the government has been busily closing tax loopholes in trust law, meaning tax benefits are reducing.
Research by HMRC reveals the main motivations behind setting up a trust now centre on retaining control of the assets.
Tax tends to be a secondary motivation, although 46 per cent of individuals do still say tax is an important factor in setting up a trust.
What if you just give money away?
Before going in to too much detail on trusts, first things first. The simplest way to pass on money to loved ones before you die is to give it to them.
‘The main choice you have is whether to give in your lifetime or to leave a legacy,’ explains Jeannie Boyle, of wealth management firm EQ Investors. ‘The most important question to ask yourself is whether or not you might need access to the money in the future.
‘Bear in mind that you may need more money than expected later in life to cover care costs. If this is the case it’s probably best to leave money via your will. You can do this by making a direct bequest or by using your will to set up a trust to control the money.’
If you decide you have enough to make a bequest while you’re alive, every tax year you are entitled to give a certain amount of money away without having to pay additional tax on it.
Gifts of capital up to £3,000 a year can be made free of inheritance tax (IHT) and unlimited gifts from your surplus income can also be made IHT-free – so long as you can show that these don’t affect your standard of living.
Smaller gifts of £250 per person are also allowable but can’t be to the same people you have made other tax-exempt gifts to.
If you want to give away more than this each tax year, those who receive the gifts may have to pay inheritance tax if you die within seven years.
Once a gift is received it is the property of the recipient and any taxable income or gains after the gift has been made, are taxed on them.
‘The easiest way is for parents and grandparents to make direct gifts to children,’ says Danny Cox, chartered financial planner at Hargreaves Lansdown.
‘This gives the child immediate access to the money or gift to do with what they want. But if parents and grandparents want to make a gift and still dictate some control, there are various options.’
It’s a widely held belief that the easiest way to give money away but prevent children from accessing it until they reach 18, is to set up a trust.
However, there are other products you should probably consider before you start down the trust route, says Cox. We explain these below
Using a trust to control money
For a gift to be effective in reducing inheritance tax, it needs to be irrevocable and you can no longer benefit from access to it.
The best way to make a permanent gift and retain control over the assets is to set up a trust.
‘A trust holds assets such as shares or funds for beneficiaries under the watchful eyes of trustees,’ explains Cox.
‘Trusts are used to set aside assets so that there is certainty the beneficiaries will receive the benefits at a later date.
‘Typically the beneficiaries are children or grandchildren so a trust enables money to be set aside for them for when they are older.’
The simplest version of this is a bare trust. This is a simple but binding legal arrangement, where assets are held by a trustee, for example a parent or grandparent, for the benefit of a beneficiary – a child for example.
They can also be known as absolute trusts, as typically the beneficiary has an immediate and ‘absolute’ right to the assets from age 18.
The problem with using a bare trust to control money is that beneficiaries over 18 can get at the money or assets if they want to.
Tax benefits of a bare trust
As soon as any money or investments are put into a bare trust they are taxed as if they belong to the child, which usually means there is little or no tax to pay on any income or gains.
Most children can ‘earn’ income of up to the personal allowance of £11,500 tax-free, they also get a savings allowance of up to £1,000 of interest per year tax-free and a £5,000 per year tax-free dividend allowance.
That delivers a total of £17,500 but there is a crucial thing to consider if parents give them money.
‘There is an exception to this rule and it concerns monetary gifts from parents,’ adds Cox. ‘If the income from such a gift exceeds £100 per year the parent will have to pay tax on all the trust’s income.
‘This is another reason grandparents often use bare trust arrangements.’
In the long term, bare trusts can help with inheritance tax planning, as assets paid into the trust are treated as a gift, and can be a potentially exempt transfer.
Potentially exempt transfers mean that if the donor survives seven years beyond making the gift, it will not form part of their estate when they eventually pass away and no IHT will need to be paid.
If, however, the donor dies within seven years, inheritance tax is payable by the child inheriting at tapered rates. You can find out more on these here.
Bare trusts can also be used for school fees planning as the benefits can be distributed before age 18 for the child’s benefit.
|Years between gift and death||Tax paid|
|Less than 3||40%|
|3 to 4||32%|
|4 to 5||24%|
|5 to 6||16%|
|6 to 7||8%|
|7 or more||0%|
Keeping more control with a discretionary trust
A discretionary trust relies on the ‘discretion’ of the trustees who are appointed by the donor to manage the trust.
The advantage here is that whereas in a bare trust the assets must be distributed to beneficiaries who are over 18 if they ask for them, with a discretionary trust the trustees can retain assets until they think it is the right time for them to be distributed.
‘This is more complicated to set up but it gives the trustees far more control over what happens to the money,’ says Boyle.
‘The trustees determine who can benefit and when – none of the beneficiaries has a right to the funds. It means the family assets are protected from bankruptcy, divorce or financial irresponsibility.’
If you have more income than you normally spend you can set up a regular payment into the trust. This could help with education costs or saving for a deposit.
The trustees can also choose who will benefit and how much they will receive, which means that they may ‘pass over’ some of those listed as ‘potential beneficiaries’.
It is very important therefore that you help the trustees by indicating who you would like to benefit from your plan, either by naming them in the potential beneficiaries section of the trust, or by completing an expression of wishes form which can be kept with the trust form.
The expression of wishes form is not a legally binding document but it will help to guide the trustees when the time comes for them to distribute the policy benefits to the beneficiaries.
Unlike a bare trust, new beneficiaries can be added to the trust or removed from it. This can be useful if, for example, you have another child or grandchild or if you fall out with someone you previously wanted to benefit from the trust.
One of the risks of a discretionary trust is that the trustees have considerable influence over the trust, its assets and its distribution.
So choosing the wrong trustees can lead to complications in the future. For example, they could refuse to allow you to add another beneficiary or appoint another trustee. They could also refuse to give some of the trust fund assets to a beneficiary, even though you would have wanted them to receive it.
The discretionary trust also includes a power for the trustees to make loans to individuals who may be beneficiaries of the trust.
The tax problems with a discretionary trust
If you are thinking of giving money away but would like to retain control over it, the discretionary trust option probably looks quite good to you. However, there is one crucial thing to consider: tax.
The tax position for discretionary trusts makes them an expensive solution for many people. How they are taxed is also VERY complicated and in some cases, it’s necessary to register discretionary trusts with HMRC.
As with any other gift, transferring assets into a discretionary trust means there is inheritance tax to pay if you exceed the nil rate band allowance and die within seven years.
Inheritance tax assessments are also mandatory on discretionary trusts every 10 years. When the value of the trust – original assets plus any returns AND any payments made out of the trust – surpasses the nil rate band threshold of £325,000, you will start to pay tax on it at 6 per cent.
Once the trust value overtakes this threshold, any future payments made to beneficiaries are also immediately subject to inheritance tax payable by the beneficiary.
For most trusts, investment interest and rental income up to £1,000 is taxed at 20 per cent, while dividend income is taxed at or 7.5 per cent.
Above £1,000 trust income is subject to special trust rates of tax. These are 45 per cent for non-dividend income and 38.1 per cent for dividends.
The normal tax-free annual income allowance of £11,500, the £1,000 annual personal savings allowance and £5,000 annual dividend allowance do not apply to trusts, so holding income producing assets can be very expensive for trustees.
Capital gains tax also applies to trusts, with the tax-free threshold set at half of an individual’s – £5,650 in the 2017/18 tax year.
Gains above this amount are taxed at 20 per cent or 28 per cent for residential property.
If the money is accumulated income, then the trustees must pay 45 per cent tax and the beneficiary can reclaim the difference between that and their own marginal tax rate.
Boyle says: ‘One way to make managing a trust much easier is to invest the assets into an investment bond. This type of investment does not produce regular income or gains, so there is no need to complete an annual self-assessment.
‘Investment bonds are divided into a number of different segments. Beneficiaries can be assigned segments which they can then encash once they personally own the investment.’
Taking professional advice if you plan to set up a discretionary trust is a good idea.
Can you make life less complicated with an Isa or Sipp?
Getting a trust set up will require help from a professional tax adviser, a solicitor or financial adviser with the specialist knowledge needed
It is also possible, however, to use financial products that are easily at everyone’s disposal to invest sums for your children, says Hargreaves Lansdown’s Danny Cox.
Invest or save into a Junior Isa
Cox: A trust enables money to be set aside for children for when they are older
Junior Isas replaced child savings accounts several years ago and offer adults the option to set up an account on behalf of a child from birth.
‘Once set up, money can be saved into a Junior Isa by anyone up to a maximum of £4,128 a year,’ says Cox.
‘This is a tax-free savings or investment account where the child takes ownership at age 18 when it is converted into an adult Isa.’
The advantage of the Junior Isa is that, just like an adult Isa, all interest accrued is tax-free and can therefore grow unfettered by anything – except of course inflation.
It also puts restrictions on children under 18 accessing funds, which is similar to a simple trust.
Boyle adds: ‘Anyone can pay into a Junior Isa on behalf of a child but the account must be opened by their parent. Up to age 18 the parent controls how the money is invested, but once the child reaches 18 they are in the driving seat.’
If you paid £4,128 every year for 18 years and the money grew at 3 per cent each year the total fund could be close £100,000 – quite an alarming sum of money for an 18 year old to have access to.
‘It’s also worth remembering that the money cannot be accessed before 18 under any circumstances, so Junior Isas aren’t suitable for school fees but are for higher education or university costs planning,’ adds Boyle.
Remember, however, any money you put into this will still be subject to inheritance tax if it exceeds the allowable exemption limits.
A pension for the kids with a Junior Sipp
This works in a similar way to a Junior Isa but the money you put in cannot be accessed by the beneficiary (child or grandchild) until they are at least aged 55 at the earliest, with this age restriction likely to rise to 57 and beyond in the future as the government raises the state pension age.
This is because the Junior Sipp is a self-invested personal pension – a wrapper that offers all of the same tax benefits as an ordinary Sipp but, being a pension, has severe penalties applied if you want to access the money earlier than this.
Tax relief on pension contributions is available to anyone under 75 even if they don’t have any earned income.
As with any pension, money put in is eligible for tax relief at the rate the account holder pays income tax, with the minimum at basic rate of tax – currently 20 per cent.
The maximum you can pay in is either your income or £40,000 per year (including the automatic basic rate tax relief uplift), or for someone with no income it is £2,880 a year and the government will top this up to £3,600.
Invest in your name to keep control of your money
Opening an investment account in your own name allows you to make sure the money can be accessed when needed and can’t be misused by an 18-year old.
Most people find they pay no tax or very little tax on investments.
The dividend allowance and personal savings allowance cover any taxable income generated and the £11,300 capital gains allowance covers the profit on buying and selling different investments.
To put this type of arrangement on a formal footing you can set up a designated account – this recognises that the account is intended for the designee.
This will remain part of your estate, however.
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