Discounted Gift Trusts

A DGT allows individuals (a Settlor) to gift a lump sum into Trust while retaining the right to regular capital payments and reducing the amount of Inheritance Tax (IHT) that might eventually have to be paid from their estate.

When establishing the DGT, the Settlor requests regular capital payments payable for their lifetime, or until the fund is exhausted. These payments are generated from partial withdrawals from an investment bond via the 5% withdrawal facility.

The DGT provider will calculate how much of the bond’s value will be needed to provide these withdrawals, which will involve an estimation of the Settlor’s life expectancy via medical underwriting, health questionnaires and a GP report.

The capital needed to provide the required withdrawals is known as the discount and this reduces the value of the Settlor’s gift to the DGT for IHT purposes.

The reduced value of the ‘gift’ may remain within the Settlor’s estate for seven years, dependent upon the type of underlying Trust structure used.

The value of the discount and any investment growth in the Trust is considered to be immediately outside of the Settlor’s estate and should not be subject to IHT.

There are two types of Trust which may be used.

Absolute Trust (sometimes referred to as a Bare Trust)

Under an Absolute Trust, the gifted amount is considered a Potentially Exempt Transfer (PET) by the Settlor. After seven years it is considered to be exempt from the Settlor’s estate for IHT purposes. The value of the DGT (less the discount) is considered to be held within the estate of the named beneficiaries.

When using an Absolute Trust, once beneficiaries have been named, they cannot be changed.

Discretionary Trust

A gift to discretionary Trust is considered a Chargeable Lifetime Transfer (CLT) by the Settlor. The CLT may cause an immediate IHT charge on the Settlor if the discounted value of the gift (together with any other CLTs made in the previous seven years) exceeds the Settlor's available nil rate band (currently £325,000). Any excess above the available nil rate band is subject to IHT at the lifetime rate of 20%, subject to grossing up if the Settlor pays the tax.

Using a Discretionary Trust structure is more flexible and beneficiaries can be added or removed by the Trustees at their discretion.

The main benefits of a DGT are:

• the Settlor immediately reduces their IHT liability by removing the value of the discount from their estate
• the remaining value of the ‘gift’ can potentially fall out of the settlor’s estate after seven years
• the Settlor retains access to capital via regular withdrawals
• future growth on the value of the Trust is outside of the Settlor’s estate for IHT purposes
• Since the Settlor retains the right to regular payments, there is no gift with reservation for IHT purposes. This means the gift is considered complete and effective for IHT planning.

Mrs Smith is aged 67, has recently taken a pension commencement lump sum (tax-free cash) from her pension fund of £250,000 and requires regular capital payments from it of 4% per annum. She would like to reduce her estate’s potential liability to IHT and be able to pass it to her two children.

She invests £250,000 in a DGT Absolute Trust for the equal benefit of her two children.

Outcomes

The DGT provider calculates that the discount will be £125,000. This immediately falls outside of Mrs Smith’s estate and will no longer be considered when calculating any potential IHT liability.

Immediate IHT saving: £125,000 @ 40% = £50,000.

The remaining £125,000 (being the total investment less the £125,000 discount) is treated as a PET for IHT purposes. After seven years from the date of the gift, this will also fall outside Mrs Smith's estate.

Potential IHT saving after a further seven years: £125,000 @ 40% = £50,000.

Assuming Mrs Smith survived for 20 years she could receive regular withdrawals from the bond of £10,000 per year(4%), totalling £200,000.

Investment growth in the Trust is considered to fall outside of Mrs Smith’s estate. As an example, if the value of the Trust grew to £400,000, investment growth would total £150,000 and the potential IHT savings on the growth in the fund would be:

Growth of £150,000 @ 40% = £60,000.

In the event of her death at this point, Mrs Smith’s children can inherit the value of the Trust, free from IHT with a total potential IHT saving of £160,000.

DGTs can be inflexible. Once established, gifted capital cannot be reclaimed by the Settlor, and the level of regular capital payments cannot be increased or decreased. Careful consideration of your likely future capital requirements is therefore essential before proceeding.

Withdrawals are usually kept within the cumulative 5% annual tax-deferred withdrawal allowance available from an investment bond, whether onshore or offshore, to avoid triggering an immediate chargeable event gain.

If the investment bond within the Trust is surrendered, this may create a chargeable event gain, which could result in an income tax liability as explained in our article ‘The key benefits of offshore bonds’.

Setting up a DGT can be complex and requires professional advice. Establishing and maintaining the Trust also comes with additional costs.

If you would like to discuss how Discounted Gift Trusts could benefit you, then please speak with your financial adviser or contact one of our Financial Planning Consultants who will be delighted to discuss this further with you.