The younger and healthier the settlor, the longer the payments will be paid for and therefore the greater the value of the regular payments. Conversely, if the settlor is older or in poorer health, their life expectancy will be shorter and the fewer payments are likely to be made, so the lower the capital value.
The value of the regular payments is not a gift for inheritance purposes as the settlor is retaining a benefit from this amount of the investment - they are effectively applying part of the investment as a regular income that ceases on death and therefore this is not a gift for inheritance tax purposes.
The gift to the trust is ‘discounted’ by the capital value of the regular payments. Any amount invested over the value of the discount is treated as a gift for inheritance tax purposes and will remain in the settlor’s estate for the next seven years.
For example, if a client invested £100,000 and requested withdrawals of £5,000 each year, depending on underwriting the value of the regular payments could be £53,000. This is outside of their estate immediately and the remaining £47,000 would be a gift..
When making any lifetime gifts there can be tax charges where discounted gifts over the available nil rate band are made and in many instances the gift should be limited to £325,000 in order to avoid any lifetime inheritance tax. Under a discounted gift trust the settlor can sometimes invest significantly more than the available nil rate band.
The discount calculation should be based on assumptions provided by HMRC and they also prescribe the actual calculation that should be used. If the provider is too aggressive in the calculation, not following HMRC guidance, or the settlor has withheld vital information then HMRC can choose to recalculate the discount in the future. This can impact not only the treatment of the whole investment but also any estate planning done before or after.
As the discount is offered at outset and based on future payments, the payments to the settlor cannot be varied during their lifetime, unless of course the investment is exhausted. Also, the trustees are unable to distribute money to the beneficiaries until their obligation to the settlor is removed on the settlor’s death.
Income tax benefits
The use of an investment bond allows the settlor and trustees to utilise the favourable tax treatment.
An investment bond is a non-income producing asset and any growth or income achieved by the underlying assets remain in the bond, and do not give rise to any immediate tax liability.
It is possible to take regular withdrawals from the bond without any immediate liability to UK income tax. Withdrawals of up to 5% of the amount invested can be taken each year and for tax purposes are deemed to be a return of capital – hence the withdrawals are termed as regular payments rather than income.