When it comes to estate planning, the concept of trusts can seem both complex and highly beneficial, especially when considering the flexibility and control they offer. Among the various types of trusts, discretionary trusts are particularly popular for those looking to retain some influence over their assets while protecting them for future generations. But are they really worth it? And how do they fit into your overall financial strategy?
What Is a Discretionary Trust?
A trust is a legal arrangement where assets such as investments, cash, or property are managed by trustees for the benefit of beneficiaries. The person who sets up the trust is known as the settlor, and they can either act as a trustee themselves or appoint others. In a discretionary trust, the settlor grants the trustees the authority to decide when and how to distribute the trust’s assets to the beneficiaries. This flexibility ensures that the trustees can take into account both the settlor’s wishes and the current needs of the beneficiaries, especially when the settlor is no longer around to make decisions.
When Is a Discretionary Trust Useful?
The key feature of a discretionary trust is its control. It is particularly useful when you want to set aside money for someone but feel they might not be responsible enough to manage it on their own. For instance, if a beneficiary is young or prone to poor financial decision-making, placing money into a trust ensures the funds are used as intended. In a case where a large inheritance is left to someone young, such as a 17-year-old, a discretionary trust ensures the funds are not squandered on short-term luxuries, but instead can be saved for important life milestones like education or purchasing a home.
However, once assets are placed in a trust, they no longer belong to the settlor. Although the settlor can still be a trustee, they must relinquish any personal control over the assets, as maintaining an interest would introduce complex tax implications.
Can a Discretionary Trust Help with Inheritance Tax?
While discretionary trusts can be an excellent way to protect assets, they don’t always offer immediate inheritance tax (IHT) advantages. Currently, individuals can transfer up to £325,000 (the nil-rate band) without incurring IHT. For any amount over this limit, a 20% entry charge applies when transferring assets into a trust. If the settlor dies within seven years of making the gift, the entry charge increases to 40%.
But here’s the catch: if you place assets within the trust and live for at least seven years, the assets will fall outside of your estate, reducing the potential IHT burden. This means not only can you remove the value of the assets from your estate, but the original gift will also reclaim your nil-rate band. Plus, any growth on the original asset within the trust will be exempt from the seven-year rule.
What Are the Downsides of a Discretionary Trust?
While discretionary trusts offer various benefits, they also come with some significant downsides. Trusts are taxed at the higher rates of a standard taxpayer, which means assets within a trust are subject to capital gains tax (CGT) at a rate of 20%, dividends are taxed at around 39%, and any other income is taxed at a steep 45%. Additionally, a trust only receives half the annual CGT allowance that an individual would, reducing opportunities to minimize tax liability.
Another downside is the periodic charge, which applies every ten years to the trust’s total value. This charge can be as high as 6%, and it adds an extra layer of financial complexity to managing a trust.
Beyond taxes, the costs of establishing and maintaining a trust can add up. Legal fees, ongoing professional trustee charges, and regular trust meetings can make it a more expensive option compared to simpler alternatives like gifting assets directly.
Is a Discretionary Trust Right for You?
Discretionary trusts are not for everyone. They require careful planning and come with a variety of complexities. In many cases, simply gifting assets directly may be more efficient and less costly than setting up a trust. If you’re considering a discretionary trust, it’s important to assess your financial situation and ensure you can afford the ongoing costs and tax liabilities. Trusts might not be suitable for everyone, especially depending on your age, health, or financial circumstances.
If you’re thinking about setting up a trust, it’s crucial to seek professional advice. A financial planner can help you determine if a discretionary trust is right for you and guide you through the complexities involved in setting one up.
Conclusion
Discretionary trusts provide a high degree of control over assets, making them an excellent option for those looking to protect their wealth for future generations. However, the complex tax implications and ongoing management costs can make them less suitable for everyone. By understanding the benefits and drawbacks, and working with a financial planner, you can determine whether a discretionary trust is the right tool for your estate planning needs.
