In Focus: Tax  

How to use trusts within estate planning

  • To understand how trusts work.
  • To learn the differences between different types of trust.
  • To be able to explain the role of the family and trustees in managing trusts.
How to use trusts within estate planning

Trusts are one of the oldest forms of financial planning, with origins going as far back as the Middle Ages.

Yet all too often they remain the subject of misunderstandings. When considering trusts, it is useful to go back to first principles and think about what a trust is trying to achieve.

Simply put, a trust is set up so that assets can be managed by one person or persons on behalf of another person or persons.

The establishment of a trust involves three parties:

  • The settlor – the person giving assets to the trust.
  • The beneficiary (or beneficiaries) – those who will benefit from the trust.
  • The trustees – those who will manage the trust on behalf of the beneficiaries.

Trusts exist in many different forms, but for the purpose of this article we will consider the use of trusts in estate planning, as opposed to those involved in investment or pension trusts.

In order to understand how trusts work and how they can be used to help clients achieve their financial objectives, it is useful to consider some of the most common misunderstandings attributed to them. Let’s consider some common myths.

Myth 1: Trusts are all about mitigating inheritance tax

It is certainly true that trusts are often used to mitigate IHT. The nil rate band for IHT has been frozen at £325,000 since 2009. If a person gifts this amount, into a trust or directly, after seven years this falls outside their estate for IHT purposes.

The annual exemption of £3,000 and the small gift allowance of £250 have been frozen since 1984.

But where IHT is a concern, families may need reminding that it is all too easy to put the tax tail in front of the investment dog. Mitigating IHT is a means to an end – the passing down of family assets – rather than the end in itself.

Families need to have an open and honest discussion with their advisers about what it is they really wish to achieve. Financial planning makes much more sense when objectives are clear.

If a person wishes to pass on assets to younger generations, a trust can help them do so and it can be an appropriate vehicle to do so tax-efficiently. 

Remember as well that trusts exist so assets can be managed by one person or persons on behalf of another person or persons. There are many situations where assistance may be sought to manage assets on behalf of another.

Perhaps the beneficiary or beneficiaries are too young, or for other reasons lack the capability to manage the assets. Perhaps the settlor does not want the beneficiary or beneficiaries to receive too much in one go and would rather inheritance is received over time in a more controlled manner.

A scenario we see frequently is a trust being used following a second marriage to secure inheritance for children of a first marriage that could otherwise find themselves disinherited.

Many families are way more complicated than the 2.4 children stereotype, and the legal formalities of a trust provides greater certainty of distribution in accordance with the wishes of the settlor. Holding assets in trust can also be a means to protect family wealth from risk of divorce or bankruptcy.