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Why Trusts are Still Powerful Tax Shelters

Why Trusts are Still Powerful Tax Shelters

At first glance, the charges arising from the use of trusts for lifetime Inheritance Tax planning seem horrendous. There’s a charge of up to 20% when assets go into a trust; up to 6% when they come out of it and up to 6% every ten years in between. We can refer to these as ‘entry charges’, ‘exit charges’ and ‘anniversary charges’.

But the important words in my description of these charges are my three repetitions of the words ‘up to’. Charges can often be kept to much lower levels or even at zero when lifetime Inheritance Tax planning with trusts is carried out carefully.

The key to keeping these charges down to manageable levels is the careful use of the nil rate band.

The nil rate band for Inheritance Tax is currently £325,000 and it is available to each of us to exempt from Inheritance Tax the first £325,000 of our estate when we die or the first £325,000 of chargeable lifetime transfers which we make.

Hence, a person who has made no previous chargeable lifetime transfers can transfer £325,000 into trust free from Inheritance Tax. In fact, by using up their £3,000 annual exemptions for this year and last year, a person who has made no previous transfers can put up to £331,000 into a trust without incurring any Inheritance Tax liability. [Last year’s annual exemption can be used this year if it is still available and this year’s exemption has been exhausted.]

OK, so we’ve avoided the entry charge, what about the exit charge and the anniversary charge?

During the first ten years of the trust’s life, the exit charge will be based on the value of the assets and funds transferred into the trust. As usual, however, the nil rate band applies to exempt the first £325,000. Hence, if no more than £325,000 was transferred into the trust in the first place, there will be no exit charges during the first ten years. This means that the opportunity still remains to shelter assets in a trust for up to ten years free from Inheritance Tax.

Admittedly, the death of the transferor within seven years of the original transfer of assets or funds will result in some Inheritance Tax but some savings will be made as long as they live at least three years.

If the trust is wound up before its tenth anniversary, then it is possible for the original transferor to avoid Inheritance Tax altogether. However, the trust assets will of course then be in someone else’s hands, meaning that a charge of up to 40% would arise on the new owner’s death.

So what if we leave the assets in the trust instead?

As we know, when the trust reaches its tenth anniversary, there will be a charge of up to 6%. The calculation of these charges is highly complex, but, in its most simplistic form, the charge is very broadly applied to the value of the trust assets on the anniversary date in excess of the nil rate band at that time.

‘At that time’ is another key phrase. The nil rate band usually increases at least in line with inflation although it is currently frozen at £325,000 until 2014. Ten years from now, in 2022, we can reasonably expect the nil rate band to be at least around £410,000 (based on an average inflation rate of 3% between 2014 and 2022) meaning that a trust with total assets having a value no more than this amount would also escape the anniversary charge.

But surely the point of using a trust is to accumulate wealth in a tax advantaged environment so we would actually want our trust investments to grow faster than inflation and thus, by implication, possibly also faster than the nil rate band.

Furthermore, to make the most of our trust shelter, we would want to ‘top it up’ each year, utilising each year’s £3,000 annual exemption plus any further sum within the increased nil rate band.

For example, we know that £331,000 could be transferred tax free (i.e. no entry charge) into a trust this year. The same person could also transfer a further £3,000 next tax year (2013/14) into the same trust without incurring any entry charge. In the year 2014/15, assuming that the nil rate band increases by 3%, they could transfer an additional £13,000 into the trust without incurring any entry charge.  The sum of £13,000 represents their £3,000 annual exemption plus the £10,000 increase in the nil rate band (assuming it increases by 3% it will be £335,000 for 2014/2015).

Continuing this strategy for seven years, I would estimate that a taxpayer would be able to shelter a total of at least £400,000 by 6th April 2019.

Now, if we assume that the trust invests the transferred funds and achieves a compound growth rate of 10% on its investments (after income tax), the total value of the trust funds by its tenth anniversary will be in excess of £950,000. The complex tax calculation applying in this scenario produces an anniversary charge of just £32,965, or less than 3.5%. Compare that with the 40% arising if the transferor had held on to these funds themselves and you can easily see what an effective shelter a trust can be even notwithstanding the anniversary charges.

New Nil Rate Bands

Why did I stop putting money into the trust after just seven years? Well, here comes the really clever part.

We don’t just get one nil rate band for life, we get a new nil rate band every seven years. Hence, seven years (and a day) after setting up the first trust, we can set up a second one and use our brand new nil rate band to make another large transfer without incurring any entry charge.

Admittedly, if you’ve been following the annual transfer strategy set out above, you won’t have a whole new nil rate band available, but most of it will be, as the original £331,000 transfer in 2012/2013 will have dropped out of the reckoning.

You therefore have the chance to set up a new trust shelter every seven years (and a day) with probable anniversary charges ten years later of only just over 3%.

Admittedly, if you carry on in this fashion, the twentieth, thirtieth and later anniversary charges are likely to be greater but I still conservatively estimate an average charge of less than 5% every ten years. That equates to a charge of less than half a percent per annum on average. It would therefore take over 80 years before the anniversary charges begin to exceed the Inheritance Tax which is saved on the transferor’s death by using the trust shelters.

In fact, my projections indicate that a couple who each have a thirty year life expectancy and who are wealthy enough to put this strategy into full effect could eventually save over £8,000,000 by making use of a series of trusts, one of which is set up every seven years.

So, quite frankly, no, I don’t think it’s the end of the line for trusts.