Want to reduce your inheritance tax but still need an income? A discounted gift trust (DGT) can help. You can reduce your tax liabilities and still get income from your assets. In this guide we’ll explain what a discounted gift trust is, how it works and who benefits.
Summary
- A Discounted Gift Trust (DGT) allows you to reduce inheritance tax and get an income.
- DGTs can be single or joint settlor trusts, joint settlor options allow payments to continue after one settlor’s death, suitable candidates are those approaching retirement or with specific income needs.
- Setting up a DGT requires consideration of trust types and management and understanding of tax implications including inheritance tax benefits and regular payments from retained rights.
What is a Discounted Gift Trust
A Discounted Gift Trust (DGT) is a complex financial instrument designed to reduce inheritance tax liabilities and allow the settlor to get an income. This double benefit makes DGTs attractive to individuals or couples with large assets who want to manage their estate without losing access to an income. HMRC recognise and accept that Discounted Gift Trusts work as intended so you can have peace of mind if you choose this route. Setting up a DGT can be considered a potentially exempt transfer (PET) for inheritance tax purposes, and if the settlor dies within seven years of making the transfer, tax may be payable depending on the conditions met.
DGTs are for individuals or couples who have surplus funds and want to make gifts and get an income. Reducing inheritance tax liabilities and still getting some income makes DGTs a popular choice for many.
These trusts are particularly useful for those who want to manage their inheritance tax and still get an income from their gifted assets.
Definition and Purpose
A discounted gift trust is a trust created by the settlor through a gift where the settlor retains the right to get regular capital payments. The main purpose of a DGT is to reduce inheritance tax liabilities and allow the settlor to get an income from the trust during their lifetime. The term ‘discounted’ means the value transferred into the trust is less than the amount invested by the settlor, it’s a unique advantage in estate planning.
Individuals or married couples/civil partners with surplus capital who want to give away funds and get an income are ideal for a DGT. This is for those with large assets to transfer funds but also need financial returns from those assets. Certain actions within a DGT, such as withdrawals or changes in the trust, can trigger a chargeable event, which has specific tax implications.
A DGT allows the settlor to transfer assets and get payments throughout their lifetime, so it’s perfect for those with surplus funds.
Elements
To set up a discounted gift trust the settlor transfers cash to the trustees who then manage the trust fund. This fund is key as it’s the capital that will benefit the beneficiaries and minimize tax.
The trust deed is key as it sets out the rules and conditions of the trust and the roles and responsibilities of the trustees to ensure everything runs smoothly and in line with the settlor’s wishes.
Who can benefit from a Discounted Gift Trust?
Individuals or couples who want to make a gift and still get withdrawals can benefit from a discounted gift trust. UK domiciled individuals who need withdrawals are ideal for a DGT.
Suitable candidates
Individuals with large assets can benefit from a discounted gift trust. These trusts reduce inheritance tax liabilities and allow the settlor to get an income. Those who want to minimize inheritance tax exposure and get financial support for their heirs are good candidates for a DGT. Candidates should have a stable income or financial assets to maintain their lifestyle while gifting a portion to trust beneficiaries.
Individuals with specific income needs and want to leave a financial legacy are ideal for a discounted gift trust. Those with dependents or beneficiaries who will need financial support in the future may find DGTs particularly useful.
Individuals approaching retirement or in good health have more time to plan their financial future so are suitable candidates considering their individual circumstances.
Joint or Single Settlor
Joint settlor versions of Discounted Gift Trusts can be more beneficial for couples. In joint DGTs payments continue at the full amount after one settlor dies so the retained payments continue. Couples have to choose between a joint settlor option or two separate single settlor trusts when setting up a DGT.
In a single settlor trust the right to income ceases on the settlor’s death whereas in a joint settlor trust it continues. Couples should consider this when planning their estate and income needs.
How to Set up a Discounted Gift Trust
Setting up a Discounted Gift Trust allows you to transfer assets and get payments throughout your life. The settlor is usually one of the trustees and must appoint at least one other to co-manage the trust.
It’s a good idea to have an additional trustee appointed from the start as a safety net.
Initial Setup
The settlor sets up a discounted gift trust by making a cash payment to the trustees. DGTs can be set up as single or joint settlor for spouses and civil partners. Existing bonds or investments need to be encashed and the proceeds used to fund the trust. The trustees will invest the trust fund by taking out an investment bond.
Understanding the tax rules is crucial when setting up a DGT, as these rules govern how the trust is taxed and managed. The trust creates two separate rights: one for the settlor to get payments and one for the beneficiaries to access the trust fund after the settlor dies. A professional trustee (e.g. a solicitor) can be appointed but they may charge for their services.
A DGT requires several key documents including application forms and tax notes. Anti-Money Laundering submissions are part of the paperwork too.
Trust Deeds and Documents
Trust deeds set out the rules and conditions of the trust. They are the legal basis of the trust and define the roles and responsibilities of the trustees.
You need to create a formal trust deed to set out the terms and conditions of the trust.
Types of Discounted Gift Trusts
Discounted Gift Trusts can be divided into three main types: absolute, discretionary and flexible trusts. Each type gives different levels of control over distributions and beneficiary rights so the settlor can choose the one that suits them best.
Absolute Trusts
Absolute trusts have fixed beneficiaries that cannot be changed once set up. In an absolute trust the beneficiaries are permanent and no changes can be made to who gets the benefits.
Beneficiaries of an absolute trust get the remaining trust assets when the settlor dies.
Discretionary Trusts
Discretionary trusts give more flexibility in distributing the trust assets. In an absolute or discretionary trust no beneficiary has a right to income or capital; the trustees decide who gets what based on current needs.
Trustees in a discretionary trust decide who and when to pay income or capital to a class of beneficiaries.
Flexible Trusts
Flexible trusts name beneficiaries entitled to trust income but allow changes to those beneficiaries. They give the option to change the beneficiary designations over time so the settlor can adapt to changing circumstances. Provisions can be included in a flexible trust to allow the trustees to manage changes in beneficiary shares.
If a beneficiary dies in a flexible trust it does not trigger immediate inheritance tax consequences if they predecease the settlor.
Tax implications of Discounted Gift Trusts
The value of the transfer in a DGT can be reduced by the value of the settlor’s retained payments for inheritance tax purposes. The treatment of a DGT for inheritance tax depends on the type of trust.
The actual discount for inheritance tax is based on the present value of the payments the settlor will get during their lifetime. The death of a settlor can affect the inheritance tax treatment of the DGT especially on any retained benefits.
Inheritance Tax Benefits
Discounted gift trusts can reduce inheritance tax liabilities through potentially exempt transfers. An absolute trust DGT incurs no immediate inheritance tax and does not fall under gift with reservation rules. Inheritance tax planning is generally not needed when using non-income producing assets unless a chargeable gain arises. Gains on UK bonds within a DGT are not liable to basic rate tax, as the tax is considered to have already been paid at the basic rate.
Retained rights to income are deemed to be held on bare trust for the settlor so are taxable as chargeable gains. The present value of future retained payments reduces the value of the gift for inheritance tax purposes if the settlor survives for 7 years. Effective management of retained payments is key; they should be used not accumulated to get the most inheritance tax benefits.
Chargeable gains are taxed on the settlor and there is no right to reclaim from the trustees for these assessments. Medical underwriting evidence is required for HMRC to agree to a discount for the settlor which affects overall income tax charge.
Income Tax
Payments from a discounted gift trust are income tax considerations. Payments to the settlor should be used not accumulated to maintain effective estate planning.
Discount Calculation
The discount for a DGT is calculated based on the present value of the payments the settlor will get during their lifetime. The value of the settlor’s retained payments can reduce the value of a DGT for inheritance tax purposes. The settlor’s gift value is reduced by the estimated future retained payments which reduces their inheritance tax liability.
HMRC has guidance in the Inheritance Tax Manual on how to calculate the discounts.
Life Expectancy and Medical Assessments
Medical underwriting is key to estimating a settlor’s life expectancy and the discount. The underwriting process is critical in assessing a settlor’s life expectancy in a DGT. HMRC requires medical underwriting evidence before they will agree to a discount especially for older settlers.
HMRC uses a practical approach where they consider the settlor’s age at the next birthday when calculating life expectancy at the 10th anniversary. For joint settlor DGTs the discount is calculated on combined life expectancy split between each settlor’s individual expectancy.
IHT Liability
The value of the settlor’s retained payments reduces the value of the gift for IHT purposes. The settlor’s right to receive payments ceases on their death which has no IHT value.
If the settlor survives for 7 years after the trust is established the full gift is IHT free. But a failed PET may incur IHT if the settlor dies within 7 years.
For discretionary and flexible trusts any taxable amount is calculated on the settlor’s retained payments and previous chargeable transfers.
Ongoing Management
Ongoing management of a DGT requires careful monitoring by the trustees. On the settlor’s death the value of their payment stream is nil and is not in the estate and makes the estate administration much simpler.
In a joint settlor DGT withdrawal payments continue until the death of the surviving settlor so the income stream is uninterrupted. On the settlor’s death the trustees have two options. They can distribute the remaining funds to the beneficiaries or hold them in the trust.
Payments and Withdrawals
Settlers receive fixed regular payments from a DGT for their lifetime. Once established the regular payments cannot be changed during the settlor’s lifetime. Regardless of the trust type the settlor’s payment entitlements remain the same.
Trustees have the power to make withdrawals. This can be to satisfy the settlor’s entitlement or to meet the trust’s liabilities. Regular withdrawals are arranged to provide capital to the settlor. These regular payments are not exit charges as they are a bare trust for the settlor.
Investment Changes
Trust deeds dictate whether investments in a DGT can be changed. Trustees must ensure any new investments provide the settlor’s right to receive regular capital payments.
This allows the trust to adapt to changing market conditions while maintaining the settlor’s income stream.
Events and Their Impact
Events that can affect a DGT include significant events such as the settlor or beneficiaries dying. When the settlor dies it triggers a series of events on the management and distribution of the trust.
Trustees can only make payments to beneficiaries after the death of the settlor or both settlors in a joint plan.
Settlor’s Death
On the settlor’s death the trustees must manage the remaining funds in accordance with the trust and the settlor’s wishes as expressed in the trust deed. In a joint settlor scenario the death of one settlor does not terminate the trust immediately; payments can continue to the surviving settlor.
If the settlor dies within 7 years of setting up the DGT it could trigger IHT on the gifts made. Taper relief can reduce the IHT owed and this will give an immediate reduction. This reduction applies if death occurs between 3 and 7 years after the DGT was set up.
Beneficiary’s Death
If a beneficiary of an absolute DGT predeceases the settlor the value of their share is in their estate. The value of a deceased beneficiary’s share in an absolute DGT is calculated in the same way as the 10 yearly charge but discounted for ongoing payments.
Periodic and Exit Charges
DGTs can have charges every 10 years known as periodic charges based on the value of the trust at that time. DGTs under the relevant property regime can have a 10 year IHT charge at each anniversary.
These charges are calculated by the value of the trust plus future income payments and buyer interest.
10 Yearly Charges
The IHT charge at 10 years is based on the value of the trust plus future income payments and buyer interest. At 10 years the IHT calculation for the value of the trust will include future income payments expected during the settlor’s lifetime.
The 10 year discount is available even for settlors aged 90 or over whereas the initial discount was not.
Exit Charges on Distributions
Upon distribution exit charges are based on the effective rate from the last 10 year charge or the rate at the trust’s creation. Capital distributions to beneficiaries can trigger an exit charge calculated on the effective IHT rate at the last 10 year review.
Distributions to trust beneficiaries on the settlor’s death can trigger exit charges for IHT purposes.
Conclusion
In summary Discounted Gift Trusts are a powerful tool to manage IHT liabilities and provide an income stream for the settlor. By planning and understanding the different types of trusts, tax implications and management strategies individuals can get the most out of a DGT. Whether an absolute, discretionary or flexible trust the key is to match the trust structure to personal financial goals and estate planning needs.
FAQs
What is the purpose of a Discounted Gift Trust?
The purpose of a Discounted Gift Trust is to reduce IHT liabilities and get an income. This will help with financial planning and wealth preservation.
Who is a DGT for?
A DGT is for individuals or couples with large assets who want to reduce IHT liabilities and still get income from the gifted assets. This will help with financial planning and asset management.
What are the types of DGTs?
There are three types of DGTs: absolute trusts, discretionary trusts and flexible trusts. Each type has different management and distribution options for beneficiaries.
How are periodic and exit charges calculated for a DGT?
Periodic charges for a DGT are every 10 years based on the value of the trust. Exit charges are based on either the effective rate from the last 10 year charge or the rate at the trust’s creation.
What happens to a DGT on the settlor’s death?
Managed and distributed in accordance with the trust deed, with ongoing payments to the settlor if applicable.
