Trust to Avoid IHT: How Trusts Reduce Inheritance Tax

Inheritance tax (IHT) can take up to 40% of everything you leave above the nil-rate band. For many families, that means a significant portion of a lifetime’s savings, investments or property passing to HMRC rather than the people you care about. A trust can help, but it is not a simple fix. This guide explains how trusts work for IHT planning, what the charges are, which trust types suit different situations, and what has changed recently that makes planning more urgent.

What Is a Trust and How Does It Work?

A trust is a legal arrangement in which you (the settlor) transfer assets to trustees, who hold and manage them for the benefit of named beneficiaries. Once assets are inside a trust, they are no longer legally yours. That is the core reason trusts can reduce IHT: assets outside your estate are generally not counted when HMRC calculates your IHT bill.

Three parties are always involved:

• The settlor creates the trust and transfers assets into it. You set the terms in a legal document called the trust deed.

• The trustees manage the trust assets. They have a fiduciary duty to act in the best interests of the beneficiaries at all times, not in their own interests or yours.

• The beneficiaries receive income, capital, or both, according to the terms of the trust deed. Beneficiaries can be individuals, charities, or a class of people such as “my children and grandchildren”.

Trusts are governed by a trust deed, which sets out the rules trustees must follow. Getting the deed right from the start matters enormously, which is why professional advice is essential before you proceed.

Types of Trust Used in IHT Planning

Different trusts have different IHT treatment. Choosing the wrong type can mean unexpected tax charges or failing to achieve the savings you intended.

Discretionary trusts

Trustees decide how and when to distribute assets among a class of beneficiaries. This flexibility suits families with changing circumstances. However, discretionary trusts are classed as relevant property trusts by HMRC, which means they are subject to three potential IHT charges (explained in the next section). They are the most commonly used trust in IHT planning, but also the most complex.

Bare trusts (absolute trusts)

Assets are held for a named beneficiary who has an absolute right to them, usually from age 18. There is no flexibility once the trust is set up. Transfers into a bare trust are treated as potentially exempt transfers (PETs), meaning no IHT is due if you survive seven years. Bare trusts are straightforward and often used for children’s savings or education funds.

Interest in possession trusts

One beneficiary (the life tenant) has the right to receive income from the trust assets during their lifetime. When they die, the capital passes to the remainder beneficiaries. A common example is a surviving spouse receiving income from a family home held in trust, with the property then passing to children on the spouse’s death. The life tenant is treated as owning the underlying assets for IHT purposes, so the assets form part of their estate when they die. The spousal exemption can apply here, making these trusts useful in blended family planning.

Will trusts

These are created by your will and come into effect on your death. They are often used to hold assets for a surviving spouse or to protect a share of the family home. A will trust does not reduce IHT on your own death, but it can help manage IHT on the second death and protect assets for the next generation.

Trusts for bereaved minors

If a child loses a parent, a bereaved minor trust can hold assets until the child reaches 18. These trusts receive favourable IHT treatment: there are no periodic or exit charges, provided the trust meets HMRC’s conditions. The child must become entitled to the assets at 18.

Disabled person’s trusts

Trusts set up for a beneficiary who meets HMRC’s definition of a disabled person receive special treatment. They are not subject to the periodic and exit charges that apply to discretionary trusts. The disabled beneficiary is treated as owning the assets for IHT purposes, but the trust itself is not charged as a relevant property trust. This makes them significantly more tax-efficient for families planning for a vulnerable beneficiary.

The Three IHT Charges on Discretionary Trusts

If you are considering a discretionary trust, you need to understand three separate IHT charges. Many people are surprised to learn that trusts can attract IHT charges of their own, not just savings.

The entry charge (chargeable lifetime transfer)

When you transfer assets into a discretionary trust, this is a chargeable lifetime transfer (CLT). If the value transferred exceeds your available nil-rate band (currently £325,000), the excess is charged to IHT at 20% on entry. For example, if you transfer £525,000 into a discretionary trust and have used none of your nil-rate band, the first £325,000 is covered by the nil-rate band and the remaining £200,000 is charged at 20%, giving an immediate IHT charge of £40,000. If you die within seven years, a further charge may apply to bring the total up to 40%.

The 10-year anniversary charge

Every ten years, HMRC charges IHT on the value of assets held in a relevant property trust. The maximum rate is 6% of the value above the available nil-rate band. In practice, the calculation is more complex, but 6% is the ceiling.

A simple example: a discretionary trust holds assets worth £600,000 at its 10-year anniversary. The nil-rate band is £325,000. The chargeable amount is £275,000. The maximum charge is £275,000 x 6% = £16,500. This is paid from the trust assets, not by the beneficiaries personally.

Exit charges

When assets leave a relevant property trust, for example when trustees distribute capital to a beneficiary, an exit charge applies. The rate is proportional to the time elapsed since the last 10-year anniversary. Exit charges are generally lower than the 10-year charge, but they are a real cost to factor into your planning.

These charges mean that discretionary trusts are not a way to avoid IHT entirely. They are a way to manage and reduce it, particularly when combined with other strategies. A financial adviser can model the charges against the IHT savings to show you whether a trust makes financial sense in your situation.

The Seven-Year Rule, PETs and Taper Relief

The seven-year rule is central to most trust-based IHT planning. When you transfer assets into a bare trust, this is treated as a potentially exempt transfer (PET). No IHT is due at the time of the gift. If you survive seven years from the date of the transfer, the gift falls outside your estate entirely and no IHT applies.

If you die within seven years, the gift is brought back into your estate and IHT may be due. However, taper relief reduces the IHT charge on gifts made between three and seven years before death:

• 3 to 4 years before death: 20% reduction in the IHT charge

• 4 to 5 years before death: 40% reduction

• 5 to 6 years before death: 60% reduction

• 6 to 7 years before death: 80% reduction

Taper relief applies to the tax charge, not the value of the gift. It only helps if the gift exceeds the nil-rate band. This is a common source of confusion, so it is worth discussing with an adviser before assuming taper relief will significantly reduce your liability.

For chargeable lifetime transfers into discretionary trusts, the seven-year clock also runs, but the entry charge already paid is taken into account when calculating any additional IHT on death.

Worked example: gifting assets into a trust

A family property worth £750,000 is placed into a trust. Provided the settlor survives seven years, the property is removed from the estate — a saving of £750,000 × 40% = £300,000 in inheritance tax. During those seven years the property can still generate rental income, which is distributed to the beneficiaries.

The same principle applies to cash and investments. A family places £500,000 into a discretionary trust. After seven years those funds are no longer part of the estate, saving £500,000 × 40% = £200,000 in inheritance tax, while the trustees distribute £20,000 a year towards university fees and retain the balance for future needs.

The Gift with Reservation of Benefit Trap

One of the most important rules to understand is the gift with reservation of benefit. If you transfer assets into a trust but continue to benefit from them, HMRC treats the assets as still forming part of your estate for IHT purposes. The gift is ignored.

A common example: you transfer your home into a trust but continue to live in it rent-free. Because you are still benefiting from the property, it remains in your estate. The trust achieves nothing for IHT purposes in this scenario.

To avoid this trap, you must genuinely give up the asset. If you want to continue living in a property, you would need to pay a full market rent to the trust. This has income tax implications for the trust and is rarely straightforward.

The reservation of benefit rules also apply to settlor-interested trusts, where the settlor or their spouse can benefit from the trust assets. HMRC has specific rules that prevent you from placing assets in trust and then benefiting from them yourself. A Discounted Gift Trust (described below) is structured carefully to avoid this trap while still allowing the settlor to receive a fixed income stream.

Two Strategies That Work Well: Discounted Gift Trusts and Gift and Loan Trusts

These two structures are worth understanding in detail because they solve a problem many people face: wanting to reduce IHT without giving up access to funds entirely.

Discounted Gift Trust

A Discounted Gift Trust allows you to place a lump sum into a trust while retaining the right to receive fixed regular payments for the rest of your life. Because you retain this income stream, the value of the gift is reduced, or “discounted”, for IHT purposes. The discount reflects the actuarial value of the payments you will receive.

For example: you place £500,000 into a Discounted Gift Trust. An actuary calculates that the value of your retained income stream is worth £250,000. The gift into the trust is therefore valued at £250,000 for IHT purposes, not £500,000. If you survive seven years, that £250,000 falls outside your estate. The IHT saving is £250,000 x 40% = £100,000.

The key point is that you cannot access the capital once it is in the trust. You receive only the fixed income payments. This is what makes the structure compliant with the reservation of benefit rules.

Gift and Loan Trust

A Gift and Loan Trust works differently. You lend a sum of money to the trust rather than gifting it. The trust invests the loan, and any growth on the investment accumulates outside your estate. You can recall the original loan in instalments if you need funds, but the growth remains in the trust.

For example: you lend £1,000,000 to the trust. Over time, the trust investments grow to £1,500,000. The £500,000 growth is outside your estate, saving £500,000 x 40% = £200,000 in IHT. The original £1,000,000 loan remains part of your estate, but it does not grow further once it is inside the trust.

This strategy suits people who want to retain access to their capital while removing future growth from their estate. It is particularly effective when investment returns are expected to be strong over a long period.

Life Insurance in Trust

Placing a life insurance policy in trust is one of the simplest and most cost-effective IHT planning strategies available. If a policy is not in trust, the payout forms part of your estate and may be subject to IHT at 40%. Placing it in trust means the payout goes directly to your beneficiaries, outside your estate, with no IHT and no need to wait for probate.

A practical example: assume that the value of your estate means that your IHT bill on death is £1,000,000. A whole-of-life insurance policy worth £1,000,000 is purchased and placed in trust. On your death, the policy pays out directly to the trust, covering the IHT bill in full. Your beneficiaries inherit the estate intact without needing to sell the family home or other assets to pay HMRC.

The cost of the insurance premiums is the main consideration. For older clients or those in poor health, premiums can be significant. However, for many families, this remains the most straightforward way to protect an estate from a large IHT bill.

The April 2027 Pension Changes and Why They Matter Now

Currently, pension funds sit outside your estate for IHT purposes. This has made pensions a popular way to pass wealth to the next generation. From April 2027, the government intends to bring unused pension funds within the scope of IHT. This is one of the most significant changes to estate planning in a generation.

If you have a large pension pot that you planned to leave to your children or grandchildren, the tax position will change materially. Assets that were previously IHT-free may become subject to 40% tax. For many people, this makes trust planning more relevant than it has been for years, because other assets may need to be restructured to compensate for the loss of the pension exemption.

The rules are still being finalised, but the direction of travel is clear. If you have a pension worth more than your likely spending needs in retirement, now is a good time to review your overall estate plan, including whether a trust could help offset the impact of this change.

Setting Up a Trust: Practical Steps, Costs and HMRC Registration

How to set up a trust

1. Define your objectives. Are you trying to reduce IHT, protect assets for vulnerable beneficiaries, or both?

2. Choose the right trust type. This depends on your assets, your beneficiaries and how much flexibility you need.

3. Appoint trustees. Choose people with the time, financial literacy and integrity to manage the trust properly. A mix of family members and a professional trustee, such as a solicitor or financial adviser, often works well.

4. Draft the trust deed. This is a legal document and must be prepared by a qualified solicitor. It sets out the rules trustees must follow.

5. Transfer assets into the trust. This is a legal transfer of ownership and must be done correctly to be effective.

6. Register the trust with HMRC.

Trust Registration Service

Since 2022, most UK trusts must be registered with HMRC’s Trust Registration Service (TRS). This is a mandatory compliance requirement, not optional. Trustees are responsible for registering the trust and keeping the register up to date. Failure to register can result in penalties. Your solicitor or financial adviser can guide you through this process, but you should be aware of it before you proceed.

Costs

Setting up a trust involves real costs that you should factor into your planning:

• Solicitor’s drafting fees: typically £1,000 to £3,000 or more, depending on the complexity of the trust deed and the assets involved.

• Financial adviser fees: for structuring the trust within your wider estate plan and recommending the right trust type.

• Annual trustee fees: if you appoint a professional trustee, expect ongoing fees for administration, investment management and tax reporting.

• Tax compliance: trusts have their own income tax and capital gains tax obligations. Trust income is taxed at higher rates than personal income in many cases, and trustees must file annual tax returns with HMRC.

These costs are real, but for estates with significant IHT exposure, the savings typically outweigh them considerably. A financial adviser can help you model this clearly.

Advantages and Disadvantages of Using a Trust for IHT

Advantages

• Reduces your taxable estate: assets transferred into trust are generally outside your estate after seven years, reducing the IHT bill for your beneficiaries.

• Control over distribution: you set the terms in the trust deed. Trustees must follow them, so you can specify when and how beneficiaries receive assets, protecting younger or more vulnerable beneficiaries from receiving large sums before they are ready.

• Asset protection: trust assets are generally protected from a beneficiary’s creditors, divorce settlements or poor financial decisions, because the beneficiary does not own the assets outright.

• Flexibility: discretionary trusts allow trustees to respond to changing family circumstances, redirecting assets where they are most needed.

• Avoids probate delays: assets in trust pass directly to beneficiaries without waiting for probate, which can take months or longer.

Disadvantages

• Loss of control over assets: once you transfer assets into most trusts, you cannot take them back. This is a significant and permanent decision. If your circumstances change, you cannot simply undo the trust.

• Ongoing tax charges: discretionary trusts face 10-year anniversary charges and exit charges. These are manageable but must be planned for.

• Complexity and cost: trusts require professional set-up, ongoing administration and annual tax reporting. The costs are real and ongoing.

• Impact on means-tested benefits: if a beneficiary receives assets from a trust, this could affect their entitlement to means-tested benefits such as Universal Credit. Trustees need to be aware of this when making distributions.

• Income tax on trust income: trusts pay income tax at higher rates than individuals in many cases. Discretionary trusts pay 45% on income above a small standard rate band. This needs to be factored into the overall planning.

• Capital gains tax: transferring assets into a trust can trigger a capital gains tax charge if the assets have increased in value. Hold-over relief may be available in some cases, but this needs careful advice.

Is a Trust Right for You?

A trust is not the right answer for everyone. It works best when you have a clear objective, assets that justify the cost and complexity, and beneficiaries who will genuinely benefit from the structure. The April 2027 pension changes, combined with frozen nil-rate bands, mean that more families than ever are likely to face an IHT bill. Starting to plan now gives you the most options.

At Frazer James, we take time to understand your full financial picture before recommending any strategy. We explain the options clearly, model the numbers honestly, and help you make a decision you feel confident about. If you would like to explore whether a trust — or other ways to reduce your inheritance tax bill — could help, we would be glad to talk it through with you.

Book your initial consultation with Frazer James, at our Bristol office, by video or by telephone. There is no cost and no obligation.

Frazer James Financial Advisers is an independent financial adviser in Bristol, Clifton. We provide independent financial advice including pension advice, investment advice, inheritance tax planning and insurance advice. Meetings are held at our offices at Square Works, 17–18 Berkeley Square, Bristol, BS8 1HB, by video or by telephone on 0117 990 2602. This article provides information about trusts and IHT planning but does not constitute personal financial advice. If you are unsure which options are suitable for your circumstances, please request advice. Investments can go up and down in value; you may get back less than you put in.

About The Author

James Mackay

On a day-to-day basis, James advises successful professionals & small business owners on how to make the most of their money. His area of expertise includes retirement planning, tax mitigation, pension options, and investing for the future.

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