How Do Trusts Reduce Inheritance Tax?

A trust is a legal arrangement where you (the settlor) hand assets to trustees, who look after them for the people you choose (the beneficiaries). For inheritance tax purposes the appeal is simple: once an asset is properly given away into most trusts, it, and crucially its future growth, is no longer part of your estate. Our guide to trusts and inheritance tax works through the mechanics in full.

The tax saving comes from two things. First, the capital you settle begins to fall out of your estate, becoming fully exempt if you survive seven years. Second, and often more valuable, any growth on those assets happens outside your estate from day one. A £300,000 portfolio that doubles over twenty years keeps £300,000 of gains away from a potential 40% charge, saving up to £120,000 in tax that would otherwise fall on your family.

A trust also solves problems that a plain gift cannot. Hand £100,000 outright to an eighteen-year-old and it is theirs to spend the next morning; settle it in trust and your trustees decide when and how they benefit. That control is why trusts are so often used for grandchildren’s education, for a disabled relative who must keep means-tested benefits, or to ring-fence money from a beneficiary’s divorce or creditors. The inheritance tax saving and the protection of the money go hand in hand.

The trade-off: control versus charges

Trusts are not a free lunch. Most lifetime transfers into a discretionary trust are chargeable straight away at 20% on anything above your available nil-rate band, with a further 20% payable if you die within seven years. On top of that, discretionary trusts face a periodic charge of up to 6% every ten years, and an exit charge when capital leaves. These figures sound alarming, but on a trust kept within the £325,000 band the entry charge is nil and the ongoing charges are modest, which is why so many trusts are sized deliberately around the allowance.

Keeping control without keeping the tax

The reason people choose trusts over outright gifts is control. A trust lets you protect money from a beneficiary who is too young, going through divorce, or simply not ready to manage a large sum. You can be a trustee yourself and steer decisions. The golden rule, though, is that you cannot benefit from the assets you have given away, if you can, the gift with reservation of benefit rules pull everything back into your estate, undoing the saving entirely.

When a trust is worth the complexity

Trusts add cost and paperwork, so they earn their place only where the control they bring is genuinely valuable. They come into their own when beneficiaries are minors, financially vulnerable or at risk of divorce; when you want assets to skip a generation; when you hold a fast-growing asset you would rather freeze in your estate now; or when you want to provide for a second family while protecting children from a first marriage. For a straightforward estate that simply sits over the threshold, a programme of gifting and good will drafting is often cheaper and just as effective.

The mechanics also matter. Trustees must be chosen carefully, registered with HMRC’s Trust Registration Service, and prepared to keep accounts and file returns. Assets inside a trust are invested by the trustees, and investments can fall as well as rise, so the trust needs a clear investment approach as much as a tax rationale. None of this is a reason to avoid trusts: it is a reason to set them up properly, with a solicitor drafting the deed and a financial adviser modelling the numbers.

Trusts sit alongside simpler tools such as outright gifting, and the right mix depends on your family and your goals. Many people combine a trust with a plan of regular gifts and use their pension and property allowances too. Our wider guide to reducing inheritance tax legally shows how the pieces fit, and the inheritance tax planning service can match you with a specialist who works with trust solicitors.

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