Using trusts to reduce inheritance tax - My Local Will Writer

A trust is a legal arrangement where assets are held by one set of people, known as trustees, for the benefit of others, known as beneficiaries. Used correctly, trusts can reduce the amount of inheritance tax your estate pays, protect assets for future generations and give you more control over who benefits and when.

They are not the right solution for every estate. But for families with assets significantly above the nil-rate band, or in more complex situations such as blended families, they are worth understanding.

How do trusts reduce inheritance tax?

When assets are placed into a trust, they may no longer be treated as part of your personal estate when you die. Inheritance tax is charged on the value of your estate above the available tax-free thresholds. Assets outside your estate are not counted in that calculation.

The rules and tax treatment differ depending on the structure. There are several types of trusts UK families use for estate planning, but the two most commonly discussed for inheritance tax purposes are discretionary trusts and life interest trusts. If you are not yet familiar with how inheritance tax works in practice, our guide to inheritance tax in the UK covers the basics.

Discretionary trusts

A discretionary trust gives trustees flexibility to decide who benefits from the assets and when. Rather than naming one person to receive a fixed share, you name a class of possible beneficiaries, typically children, grandchildren or other family members.

You can set out your intentions in a letter of wishes, but clients sometimes assume this controls what trustees do. It guides them but does not bind them. Trustees can respond to the situation as it stands, which is useful where family circumstances change. A beneficiary may be going through a divorce or financial difficulty at the point assets would otherwise have been distributed. Another may need support with education or housing costs the original plan did not anticipate.

For IHT purposes, assets in a discretionary trust may sit outside your personal estate, depending on how and when the trust was created. Discretionary trusts carry their own tax charges: a potential entry charge when assets are transferred in, a ten-year periodic charge and an exit charge when assets leave the trust. The periodic charge is calculated at up to 6% of the trust’s value above the nil-rate band, currently £325,000. That is lower than the 40% rate on death, which is why discretionary trusts tend to make more sense for larger estates. The figures need to be modelled for your specific situation before you rely on one as a planning tool.

A discretionary trust can be created during your lifetime or written into your will.

Life interest trusts

A life interest trust gives one person the right to benefit from assets during their lifetime, with the capital passing to other beneficiaries when they die. The person benefiting during their lifetime is called the life tenant. They may have the right to occupy a property, receive income from investments or draw on the trust in another way set out in the trust deed. When the life tenant dies, the capital passes to the final beneficiaries, often children or grandchildren.

This structure is widely used in second marriage and blended family situations. A surviving spouse can live in the family home and benefit from the estate, while the capital ultimately passes to children from the first marriage rather than into the new spouse’s estate. This prevents sideways disinheritance, where assets pass to a new partner and do not reach the children you originally intended to benefit. Our guide to estate planning for blended families covers this in more detail.

Life interest trusts created through a will are known as immediate post-death interest trusts, or IPDIs. In some cases, assets passing into this type of trust for a surviving spouse can benefit from the spousal exemption, meaning no IHT is due on first death. One of the most common questions around life interest trust IHT planning is whether this means the tax disappears entirely. It does not. The spousal exemption defers the liability rather than removing it, and the IHT position on second death needs to form part of any plan that uses this structure.

Trusts for vulnerable beneficiaries

Trusts can also be used where a beneficiary might not be able to manage money themselves. This could apply to a child with a disability, a vulnerable adult or someone at risk if they received a large inheritance outright.

A trust allows money or property to be managed by responsible trustees for that person’s benefit over time, rather than being handed to them directly. Trustees can make decisions about housing, care costs or other needs as they arise, rather than transferring a lump sum the beneficiary may struggle to manage.

For disabled beneficiaries, qualifying trusts receive favourable IHT treatment. The assets are treated as part of the disabled person’s estate rather than the trust’s, which can reduce or eliminate the periodic and exit charges that would otherwise apply. What clients sometimes overlook is that a standard discretionary trust does not automatically qualify. The rules are specific, the qualifying criteria are strict and the drafting matters.

Do trusts always save inheritance tax?

No. Not every estate benefits from one, and the saving is not automatic.

Trusts carry their own charges and ongoing administration costs. For estates close to the nil-rate band, these may exceed the potential saving. Trusts are also only one tool in a wider plan. Our guide to how to reduce your inheritance tax bill covers the other options worth considering alongside them.

For larger estates, the position can be more compelling. The question that matters is whether the tax saving over the life of the trust outweighs the periodic charges, exit charges and professional fees combined. Most estates need proper modelling to answer that accurately.

Trusts set up in a will

You do not need to set up a trust during your lifetime. Many people include one in their will, which takes effect when they die. This is called a testamentary trust, or will trust. If a family trust for inheritance tax purposes is part of your wider plan, this is often the most practical starting point.

Common examples include a trust for children that holds their inheritance until they reach 25, a life interest trust allowing a spouse to remain in the family home with capital passing to children on second death and a discretionary trust giving trustees flexibility over how assets are distributed among a wider group of beneficiaries.

A will trust can be particularly useful where your family situation involves a previous relationship, a second marriage, unmarried partners or a beneficiary who needs additional protection.

The trust does not exist until you die, so there is no administration during your lifetime and no immediate tax consequence at the point of creating your will. Including a trust in your will does not necessarily make it more complex or expensive to prepare. A professional will writer can include a suitable trust clause as part of the wider estate planning conversation.

If you are thinking about whether a trust belongs in your will, the next step does not have to be complicated. My Local Will Writer works with clients by phone to consider whether a trust should be included in their will and how it fits into their wider estate plan. Get a quote here.

Frequently asked questions

Can a trust reduce inheritance tax?

Yes, in some circumstances. If assets are placed into the right type of trust and are no longer treated as part of your estate, this may reduce the inheritance tax due when you die. Trusts have their own tax charges, so professional advice matters before making decisions.

What is a discretionary trust?

A discretionary trust gives trustees flexibility to decide which beneficiaries receive money or assets, how much they receive and when. You can set out your preferences in a letter of wishes, but trustees make the final decisions.

What is a life interest trust?

A life interest trust gives one person the right to benefit from assets during their lifetime, while the capital is preserved for other beneficiaries later. It is often used to provide for a surviving spouse while protecting assets for children from a previous relationship.

Are there ongoing tax charges on trusts?

Yes. Some trusts face a periodic inheritance tax charge every ten years and an exit charge when assets leave the trust. The rules depend on the type of trust and the value of the assets involved.

Can I include a trust in my will?

Yes. A trust included in a will is called a testamentary trust and comes into effect when you die. Will trusts are commonly used for children, blended families, vulnerable beneficiaries and inheritance tax planning.

Is a trust right for my estate?

A trust may be worth considering if your estate is likely to face inheritance tax, your family situation is complex or you want more control over how assets are managed after your death. It is not right for everyone. Professional advice will help you decide whether it suits your situation.