Published: October 2024
With the Budget approaching, it has been widely suggested that Inheritance Tax is one of the areas where the Chancellor might be heading to raise revenues. We therefore thought it might be a good moment to revisit the basics of Discounted Gift Trusts.
Benefits of Discounted Gift Trusts
What is a Discounted Gift Trust (DGT)? A DGT allows a Settlor to make an Inheritance Tax (IHT) effective gift into trust whilst still retaining access to a fixed income (in the form of regular withdrawals) for their lifetime (or until the trust fund is exhausted).
The value of the gift for IHT may be reduced by the assumed value of any retained payments based on the donor’s age and health at outset, and the size of the capital payments.
Access to capital
Normally for a gift to fall outside of an individual’s estate for IHT assessment after 7 years, the individual has to have given up all rights and access to the gift, otherwise it could be looked at by HMRC as a ‘gift with reservation of benefit’ which remains assessable to IHT.
However, a DGT can help individuals to reduce the value of their estate for IHT purposes and still receive payments from the trust to supplement income. The trust is worded so that regular capital payments, which are fixed at outset for the life of the settlor (settlors if joint), are payable during the lifetime of the recipient.
For example,
- £500,000 invested into a DGT with fixed withdrawals of 4% each year payable for the Settlor’s lifetime would total £20,000 per annum.
- The underlying investment vehicle for a DGT is usually an investment bond which will allow up to a maximum of 5% to be withdrawn each year for up to 20 years without immediate payment of tax (although tax is only deferred and will ultimately be payable on full or partial surrender, or when the 5% withdrawals are used up).
How tax on the withdrawals is paid depends on the type of bond. For an onshore bond basic rate (20%) tax is already deemed paid on the fund and all future tax is deferred, providing the 5% withdrawals are not exceeded.
If the Settlor is a basic rate taxpayer when the bond becomes subject to tax there is no further tax to pay on the withdrawals, provided the average gain per year when added to their income does not make them a higher rate taxpayer. If the Settlor is a higher rate (40%) or additional rate (45%) taxpayer, they will pay the difference between the basic rate already incurred and the higher / additional rate.
For an offshore bond, all tax within the bond is deferred, providing the 5% allowance is not exceeded, and when tax becomes due income tax is paid on the withdrawals. Top-slicing is available when assessing whether higher or additional rate tax is due.
Inheritance tax situation
Depending on the age, health and level of fixed payments, part of the value of a gift into a DGT may provide an immediate discount from the Settlor’s estate which results in a reduction of the amount of money in the estate assessable to IHT. The remainder of the gift will fall outside of the estate after 7 years as with any non-exempt gift into trust.
If the Settlor survives for 7 years from the date of the gift, the full amount of the gift into the DGT will be outside the estate for IHT assessment.
The Discount
The discount is best described as a reduction in the value of the initial gift based on the potential value of the withdrawals that could be received by the Settlor during their lifetime.
The discount is based on the hypothetical price a buyer would be willing to pay for the rights to the Settlor’s future withdrawals under the DGT. So the four factors that affect this price would be:
- the level of the payments (which is fixed for life),
- the Settlor’s life expectancy (based on age and health),
- the cost of the life assurance to the DGT provider in order to protect against the Settlor dying early and
- the tax due on any future payments.
The DGT provider makes an actuarial calculation based on these factors to decide what the value of the discount would be and clearly this varies greatly depending on the above factors.
Please note; HMRC have stated that a discount is only justified if sufficient evidence of health was provided at the time the discount was offered and this evidence has to be roughly equivalent to that undertaken for a life cover contract. As such the minimum requirements for a discount to be in place are a health statement from a GP or Medical Attendant’s report, and in some cases a full medical examination will be required.
What do the Trustees have to do?
The Trustees apply for a bond using the money the Settlor wishes to gift, and the Trustees then become the legal owners of the bond. The withdrawals selected at outset are fixed and cannot be changed at a later date and the level of payments is linked to the discount offered. As such at least some withdrawals must be taken for a discount to apply and the lower the withdrawals, the lower the discount.
What happens when the Settlor dies?
If the Settlor dies within 7 years of the setup of the trust, the discount will be taken into account for any IHT assessment. HMRC have the final say in this relative to the underwriting that has taken place. The Trustees must ensure no further withdrawals take place and this should be done by confirming to the bond provider to cease payments.
The actual investment, if required, can continue to be held within the trust which may be sensible for generation planning.
This blog only briefly covers the aspects relevant to Discounted Gift Trusts (DGTs) and you should be aware that the wider tax and trust implications need to be considered in greater detail.
If you would like to talk to one of our Chartered Financial Planners, please contact us on 01223 233331 or email info@mmwealth.co.uk.
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Disclaimer
Opinions constitute our judgment as of this date and are subject to change without warning. The value of investments and the income from them can go down as well as up, and you may not recover the amount of your original investment.
The information in this article is not intended as an offer or solicitation to buy or sell securities or any other investment, nor does it constitute a personal recommendation.
The Financial Conduct Authority does not regulate estate planning and tax planning.
The information contained within this blog is based on our understanding of legislation, whether proposed or in force, and market practice at the time of writing. Levels, bases and reliefs from taxation may be subject to change.
