11th November 2016
Discounted Gift Trust, the best of both worlds?
Many people have an inheritance tax (IHT) problem that they could, in theory, easily solve by making substantial gifts and then living for a further seven years.
Many people have an inheritance tax (IHT) problem that they could, in theory, easily solve by making substantial gifts and then living for a further seven years. However most people can’t afford this simple solution because they rely on their investments to maintain their standard of living.
What they’d like to do is to get their investments out of their estate, but keep the ability to take a regular income from them. The difficulty with that is that the tax rules say if you make a gift whilst retaining the right to benefit from it in any way, then it’s still regarded as yours for IHT purposes. This is termed a “Gift with Reservation” or GWR.
So how can you have your cake and still eat it? One solution might be to use a ‘Discounted Gift Trust’.
Let’s take the example of Mr Smith and assume that he has an imaginary cake worth £100,000 that he wants to give away. If he does this, but retains the right to having some or all it back in the future, this is a GWR so completely ineffective as far as IHT planning is concerned.
However let’s assume he cuts a slice out of his cake and keeps it for himself, and gives away the remainder. This is not a GWR – the slice he’s retained has not been given away, and there’s no reservation of benefit from the reminder given away.
This is what a Discounted Gift Trust (DGT) aims to achieve. It would allow Mr Smith to give away a substantial sum, yet retain the right to receive an income for the rest of his life without creating a GWR.
The slice of the cake retained by Mr Smith represents his right to receive future income payments. What’s left over is the remainder of the cake and this is given to a trust for the ultimate benefit of his beneficiaries (excluding himself).
In practical terms, Mr Smith puts £100,000 cash into a DGT. Trustees are appointed (he can be one) and they invest the cash into an Investment Bond – these are available from a variety of insurance companies. The plan is structured so that, in effect, some of the £100,000 is held in trust for Mr Smith’s sole benefit providing him with a lifetime income. This is normally no more than 5% of the amount invested, to take advantage of the 5% tax-deferred withdrawal facility under Investment Bonds.
The remainder will go into a trust held for the benefit of other beneficiaries. Using an Absolute Trust these beneficiaries are named at outset and cannot subsequently be changed. Alternatively a Discretionary Trust can be used whereby the Trustees can distribute the Bond proceeds to Mr Smith’s children, grandchildren, or indeed anyone else he may wish to include as a potential beneficiary. A Discretionary Trust is the more commonly used option.
The bond provider will set a “value” on the retained slice. This will depend on a number of factors – age, state of health, and the level of income selected. In simple terms, the greater the investor’s life expectancy, the larger the value, and conversely for those in very poor health or advanced years with a much lower life expectancy, the value may be small or even non-existent.
Let’s say Mr Smith elects to take an income of £5,000 per annum and is given a value on his retained slice of £55,000. NB; this doesn’t necessarily equal the amount that Mr Smith will actually receive - if he only survives for 5 years he would receive £25,000 (5 x £5,000). If he survives 20 years he would receive £100,000 (20 x £5,000).
The ‘value’ of £55,000 simply represents the current worth at outset of all future income payments he can expect to receive, and is the initial value of the slice retained by Mr Smith. In turn, this means that he’s actually made a gift of only £45,000, which will be a ‘chargeable lifetime transfer’ and fully outside of his estate providing he survives for 7 years.
There is in effect a discount of 55% on his total investment of £100,000, which is why it is known as a Discounted Gift Trust. The retained slice will have no value on death, so there is nothing to be included in Mr Smith’s estate.
NB: a DGT is not an appropriate solution in all circumstances. It provides a regular income, so is not suitable for those who may only need flexible or periodic access to their capital investments. Also, the investor actually needs to spend or gift away the income being received otherwise the IHT advantages are neutralised.
A Discounted Gift Trust is only one of a number of Inheritance Tax plans that we recommend to clients depending on their individual circumstances. If you would like to learn more about the subject and see how you might benefit from IHT planning specific to your own situation, please contact Nicholas Gray at Raymond James on 01622 691600