Inheritance Tax (IHT) planning is becoming increasingly important, particularly in light of the continued freezing of nil-rate bands until 2031 and the government’s proposals to bring unused pension funds into the scope of IHT from April 2027.
Amongst other options, one strategy that continues to prove valuable is the use of a Discounted Gift Trust (DGT). When used appropriately, it can help reduce an estate’s exposure to IHT while still allowing access to a regular income.
Who should consider a Discounted Gift Trust?
Many individuals face a common dilemma: they would like to pass wealth to the next generation but are not comfortable giving up full access to their capital due to affordability concerns. A DGT provides a practical solution to this problem.
It allows you to:
- Make a gift for IHT purposes
- Retain a fixed level of withdrawals for life
- Reduce the taxable value of your estate immediately
- Potentially move further value outside your estate over time
DGTs are therefore particularly relevant for individuals with surplus capital but have a shortfall when considering their income and their expenditure requirements. With forthcoming changes to the IHT treatment of unused pension funds, the tax-free cash from pensions is becoming a popular source for funding such planning.
How a Discounted Gift Trust works
A Discounted Gift Trust involves placing a lump sum investment into a trust. At the same time, you retain the right to receive regular withdrawals from that investment for the rest of your life.
A key point is that the value of your gift is “discounted” for IHT purposes. This is because part of the investment is effectively set aside to provide your lifetime withdrawals. The value of this retained right is is normally treated as reducing the value of the gift for IHT purposes, subject to underwriting and HMRC acceptance.
The remainder of the amount placed into trust will be treated as a gift and, in many cases, fall outside of your estate after seven years have passed. Any growth of the funds within the trust is also normally outside of your estate. This can be particularly useful in periods where government policy has frozen allowances while assets continue to grow in value.
An example in practice
Below is a recent example of advice we have provided. Names and details have been changed to protect client confidentiality.
David, aged 67, recently retired with a pension pot of £1m. He did not require access to his tax-free cash in retirement due to having no outstanding debts or requirements for a lump sum, while also having sufficient income from other sources, which was confirmed as part of the cash flow planning process.
After reviewing his position, £200,000 of his pension tax-free cash was placed into a Discounted Gift Trust. He chose to receive fixed withdrawals of 4% per year, equating to £8,000, providing a useful addition to his state pension and annuity income.
Outcomes:
- Due to his age and health, the provider applied a “discount” of £75,000. This meant, subject to HMRC acceptance, that only £125,000 was treated as the value of the gift for IHT purposes, with the £75,000 excluded from his estate immediately. This represents an immediate potential IHT saving of approximately £30,000 (£75,000 × 40%).
- The remaining £125,000 is treated as a gift and, if David survives seven years, may fall outside of his estate for IHT purposes.
- The trust’s investment value on day 1 is the full £200,000, and ignoring growth and withdrawals, the total potential IHT saving after seven years is approximately £80,000 (£200,000 × 40%).
- By using an appropriate investment solution, and assuming withdrawals of 4% per year, the withdrawals can be income free for in excess of 20 years, and at lower levels of withdrawal this means no further tax might be paid by David.
Summary and disclaimer
A Discounted Gift Trust can be a powerful planning tool, but it is not suitable for everyone and should be considered as part of a wider financial strategy. In particular withdrawals are fixed at outset and cannot usually be varied, and the original capital is no longer fully accessible. For those with differing circumstances, other solutions, both trust-based and not trust-based may be more suitable.
If you would like to explore whether this type of planning could be appropriate for your circumstances or understand how it fits alongside your wider financial plans, we would be happy to have a conversation with you. Existing clients can contact their adviser, and new enquiries are welcome via the contact form below.
