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An explanation of how the Discounted Gift Trust can significantly reduce Inheritance Tax exposure, by Arnold Aaron, Financial Planning Consultant.

Introduction

The Discounted Gift Trust (DGT) allows you to gift cash to a trust, held for the ultimate benefit of your beneficiaries. The aim is to avoid Inheritance Tax (IHT) on this money. Normally when you make a gift, you have to survive seven years for it to fully escape IHT at 40%. The rules dictate that you can’t use the asset once gifted, otherwise it is a Gift with Reservation of Benefit and therefore caught for IHT. The DGT, however, gets around these problems quite legitimately.

The Basic Components of a DGT

When setting up the DGT, a condition is that you take a fixed regular capital withdrawal, for life, from the trust, normally a tax-efficient 5% per annum, which you can spend as income. On setting up the arrangement, an actuarial forecast, (based on age, gender and health) is made as to how much you are going to withdraw over your lifetime. This amount is known as the donor’s fund. Because the withdrawals are fixed, you are carving out this amount for your own benefit and so it is deemed not to be part of the gift you have made to the trust. This means the gift element for IHT purposes is less than the amount you have actually gifted to the trust and hence a discounted gift.

Example - Illustrating the Benefits of a DGT

As an example, a female aged 60 in good health, gifting £100,000 and taking 5% withdrawals (£5,000) each year, results in a donor’s fund (or discount) of £67,000. It follows then for IHT purposes that she has only made a gift of £33,000 which takes the usual seven years to fall outside of the estate. The really interesting part of the arrangement is what happens to the £67,000 donor’s fund. Although this amount was carved out of the gift for tax purposes, it is still part of the trust fund itself. It therefore does not remain within the estate and so there is no IHT on it at any time.

The net result is that on setting up the Trust, the £67,000 is immediately exempt from IHT and the full benefits of the DGT in this example would be:

• 67% of the amount placed in the Trust immediately exempt from IHT.
• A  5% p.a. income for life (no Income Tax on this for the first 20 years)
• 33% of the amount placed in the Trust exempt from IHT after seven years.
• On death the Trust fund simply pays out to the beneficiaries the full value of the Trust’s assets (the donor’s fund and the gift element)
• Any growth in the fund is free of IHT

The above figures do of course work for larger sums, so a wealthy individual gifting say £1m would save an enormous amount in IHT immediately, not to mention deriving a generous £50k tax-efficient income for life – a compelling proposition.

Choice of Trust

The above example assumed a Bare Trust DGT trust was used. This means the beneficiaries cannot be changed once selected at outset and there is no limit as to how much one can gift to this type of Trust. In certain cases a discretionary trust arrangement would be more appropriate because it allows a change in beneficiaries at any time, for example to accommodate future grandchildren, or perhaps to safeguard against divorce.

Historically, however, one has been limited as to how much one can gift to a discretionary trust, because if you gift more than the available Nil Rate Band (currently £325,000) you have to pay an IHT charge of 20% on the excess. However, with a Discretionary Trust DGT it is the discounted gift that is relevant here. Taking our example above, providing the 33% deemed gifted element does not exceed £325,000 one can gift significantly more than the usual limit to a discretionary trust without triggering a tax charge - £985,000 in this case. No other vehicle allows you to gift such a large amount to a discretionary Trust arrangement without having to pay a 20% IHT charge.  

Summary

The DGT is truly unique in that it achieves an immediate reduction in the estate and fully exempts an asset from IHT after seven years, yet it allows you to take an income for life. This is recognised as a legitimate tax-saving device and HMRC even have a section advising about it on their website. One must appreciate, though, the absolute need for professional and experienced financial advice from an advisor specialising in estate planning. This must not be left to the layman and I generally work together with clients’ lawyers and accountants when advising on and setting up this vehicle.