Trusts and Inheritance Tax: Understanding the Different Types and How They Can Protect Your Wealth

Inheritance Tax (IHT) planning is an important consideration for anyone looking to preserve their wealth and pass assets on to future generations. With property prices and investment values increasing over time, more families may find that their estates are subject to Inheritance Tax.

One option for managing this potential liability is the use of trusts. Trusts can provide a flexible way to pass on wealth, protect assets and control how and when beneficiaries receive their inheritance. However, different types of trust have different tax implications, advantages and limitations.

Understanding how trusts work, and which may be appropriate for your circumstances, is an important part of effective estate planning.

What Is a Trust and How Does It Work?

A trust is a legal arrangement in which assets are held and managed by individuals or organisations for the benefit of others.

There are typically three parties involved:

-Settlor: The individual who establishes the trust and transfers assets into it.

-Trustees: The individuals responsible for managing the trust and its assets according to the trust deed.

-Beneficiaries: The individuals or organisations who may receive income or capital from the trust.

Assets placed into a trust might include cash, investments, property or life insurance policies.

Trusts can serve several purposes, including protecting assets for children, providing for vulnerable family members, controlling the distribution of wealth and potentially reducing an Inheritance Tax liability.

However, establishing a trust does not automatically remove assets from your estate for IHT purposes. The tax treatment depends on the type of trust, how it is established and whether the person transferring the assets retains any benefit from them.

Understanding Inheritance Tax in the UK

Before considering the different types of trust, it is useful to understand how Inheritance Tax works.

For the 2026/27 tax year, the standard Inheritance Tax nil-rate band is £325,000 per individual. An additional residence nil-rate band of up to £175,000 may be available where a qualifying home is passed to direct descendants.

Unused allowances can potentially be transferred between spouses or civil partners, meaning that qualifying couples may be able to pass on up to £1 million without an Inheritance Tax liability.

However, the residence nil-rate band is gradually reduced for estates valued above £2 million.

The standard Inheritance Tax rate is 40% on the taxable portion of an estate, although exemptions and reliefs may apply.

With these thresholds frozen, effective estate planning is becoming increasingly relevant for individuals who want to maximise the wealth passed on to their families.

1. Bare Trusts

A bare trust is one of the simplest forms of trust. Under this arrangement, the beneficiary has an absolute entitlement to the assets and any income generated by them.

Although trustees may manage the assets, they ultimately belong to the beneficiary. In England and Wales, a beneficiary can generally demand the assets once they reach 18.

Inheritance Tax implications

Gifts into a bare trust are generally treated as potentially exempt transfers (PETs).

This means that if the person making the gift survives for seven years, the value transferred will normally fall outside their estate for Inheritance Tax purposes, provided they have not retained a benefit.

If the individual dies within seven years, the gift may need to be considered when calculating the IHT liability.

Advantages:

-Relatively straightforward to establish and administer.

-Potentially removes assets from the settlor’s estate after seven years.

-Useful for gifting money or investments to children or grandchildren.

Disadvantages:

-Beneficiaries become absolutely entitled to the assets.

-Trustees have limited flexibility over how the assets are ultimately distributed.

-May be unsuitable where ongoing protection or control is required.

Bare trusts can be useful for straightforward gifting arrangements, particularly where the objective is to transfer wealth to the next generation.

2. Discretionary Trusts

A discretionary trust provides trustees with greater control over how assets are distributed.

Rather than beneficiaries having an automatic entitlement, trustees decide who receives income or capital, how much they receive and when distributions are made, subject to the terms of the trust.

This flexibility makes discretionary trusts particularly useful where family circumstances may change over time.

For example, a discretionary trust could benefit children and grandchildren while allowing trustees to consider their individual financial circumstances before distributing funds.

Inheritance Tax implications

Transfers into discretionary trusts are generally chargeable lifetime transfers.

Where the total chargeable transfers exceed the available nil-rate band, an immediate lifetime IHT charge of 20% may apply to the excess, assuming the trustees pay the tax.

If the settlor survives for seven years, the transfer will generally no longer be included in the calculation of tax on their death, provided there is no retained benefit.

Discretionary trusts can also be subject to periodic Inheritance Tax charges of up to 6% every ten years, together with potential exit charges when assets leave the trust.

Advantages:

-Greater flexibility over distributions.

-Can help protect beneficiaries who may be financially inexperienced.

-Useful for complex family circumstances and multigenerational planning.

-Can provide long-term management of family wealth.

Disadvantages:

-Potential entry, periodic and exit tax charges.

-More complex administration and trustee responsibilities.

-Income Tax and Capital Gains Tax treatment can be less favourable than personal ownership.

Discretionary trusts can form an important part of estate planning, particularly where maintaining control over the timing and distribution of wealth is a priority.

3. Interest in Possession Trusts

An interest in possession trust provides a particular beneficiary with an immediate right to receive income generated by the trust assets, or to enjoy the use of certain assets, during their lifetime.

However, that beneficiary does not necessarily have the right to receive the underlying capital.

For example, an individual might establish a trust allowing their spouse to receive income from investments throughout their lifetime, with the capital ultimately passing to their children.

Inheritance Tax implications

The IHT treatment depends on when and how the trust was established.

Certain qualifying interest in possession trusts, including immediate post-death interests created under a will, are generally treated as part of the life tenant’s estate for Inheritance Tax purposes.

Other interest in possession trusts established after 22 March 2006 may fall within the relevant property regime and become subject to ten-yearly and exit charges.

Advantages:

-Provides income or the use of assets to a specified beneficiary.

-Can preserve capital for future generations.

-Useful for second marriages and blended families.

Disadvantages:

-Potentially complex tax treatment.

-The income beneficiary may have limited access to capital.

-May not reduce the family’s overall IHT exposure.

These trusts can be particularly valuable where the objective is to provide financial security for one family member while preserving assets for others.

4. Discounted Gift Trusts

A discounted gift trust is a more specialised estate planning arrangement that can be suitable for individuals who want to reduce their potential Inheritance Tax liability while retaining access to regular payments.

Typically, an individual invests a lump sum through an investment bond held within a trust while retaining rights to predetermined withdrawals.

The value of the gift for IHT purposes may be discounted to reflect the actuarial value of those retained withdrawal rights.

Inheritance Tax implications

Where the arrangement qualifies, the initial discount may provide an immediate reduction in the value transferred for IHT purposes.

The remaining gift is subject to the relevant seven-year rules or chargeable lifetime transfer rules, depending on the underlying trust structure.

Any retained rights may still have value within the settlor’s estate.

Advantages:

-Potential immediate reduction in the value transferred for IHT purposes.

-Provides predetermined payments to the settlor.

-Can combine estate planning with investment growth.

Disadvantages:

-Typically offers limited flexibility to change withdrawals.

-Access to the gifted capital is restricted.

-Tax effectiveness depends on personal circumstances and the arrangement’s structure.

-Investment returns are not guaranteed.

A discounted gift trust may appeal to individuals who have surplus capital but still require a regular payment stream during retirement.

Book a meeting with an adviser to explore whether a trust could form part of your wider Inheritance Tax planning strategy.

5. Loan Trusts

A loan trust can offer an alternative for individuals who want to limit the future growth of their taxable estate without immediately giving away a substantial amount of capital.

Under this arrangement, an individual lends money to trustees, who then invest the funds for the benefit of the trust’s beneficiaries.

The outstanding loan remains repayable to the individual, while any investment growth belongs to the trust.

Inheritance Tax implications

The original loan generally remains part of the lender’s estate for IHT purposes, to the extent that it remains outstanding.

However, investment growth within the trust may fall outside the lender’s estate, provided the arrangement is properly structured.

The loan can usually be repaid in instalments, offering a degree of flexibility.

Advantages:

-Allows access to the original loan capital.

-Can help prevent future investment growth from increasing the taxable estate.

-May be useful for individuals who are uncomfortable making outright gifts.

Disadvantages:

-The outstanding loan remains within the estate.

-Does not usually provide an immediate IHT reduction on the amount lent.

-Investment performance and trust taxation can affect the benefits.

Loan trusts can be particularly useful for individuals taking a gradual approach to estate planning.

6. Trusts for Vulnerable or Disabled Beneficiaries

Trusts can also be established specifically to provide for beneficiaries who have disabilities or additional support needs.

These arrangements may allow trustees to manage funds on behalf of someone who cannot independently manage their finances.

Certain qualifying trusts for vulnerable beneficiaries receive special tax treatment.

Inheritance Tax implications

Where the relevant conditions are met, these trusts may benefit from exemptions from the usual ten-yearly and exit charges applicable to discretionary trusts.

However, assets may be treated as part of the vulnerable beneficiary’s estate on their death.

The eligibility requirements are specific, meaning careful legal and financial planning is essential.

Advantages:

-Provides ongoing financial support for vulnerable beneficiaries.

-Offers protection and professional management of assets.

-Potentially benefits from favourable tax treatment.

Disadvantages:

-Strict eligibility requirements.

-Trustees must comply with specific rules.

-Not all trusts established for vulnerable individuals qualify for special treatment.

For families supporting vulnerable beneficiaries, these trusts can play an important role in securing long-term financial wellbeing.

7. Life Insurance Trusts

A life insurance trust is another commonly used estate planning arrangement.

Rather than transferring existing investments or property into trust, an individual places a suitable life insurance policy into a trust for their chosen beneficiaries.

When the insured person dies, the trustees receive the policy proceeds and distribute or retain them according to the trust terms.

Inheritance Tax implications

Where a policy is correctly written into trust, its proceeds can generally be kept outside the policyholder’s estate for IHT purposes.

This can also allow beneficiaries to receive funds without waiting for the completion of probate, although insurer requirements and trustee administration still apply.

It is important to understand that placing life insurance into trust does not necessarily eliminate the IHT liability arising on the rest of the estate.

Instead, the proceeds may help beneficiaries meet that liability without having to sell property or other assets.

Advantages:

-Can provide funds to meet an anticipated IHT bill.

-Potentially avoids policy proceeds increasing the taxable estate.

-Allows greater control over beneficiaries.

-Can provide financial protection for dependants.

Disadvantages:

-Premiums must be maintained for the required period.

-Policy terms, exemptions and gifting rules need to be considered.

-Cover may become expensive, particularly later in life.

An independent financial adviser providing protection advice can help assess whether life insurance written into trust is appropriate alongside other estate planning arrangements.

Book a meeting with an adviser to discuss protecting your family’s financial future and making provisions for a potential Inheritance Tax liability.

Which Type of Trust Is Best for Inheritance Tax Planning?

There is no single trust that is suitable for everyone.

The most appropriate arrangement depends on factors such as the size of your estate, financial objectives, family circumstances, investment requirements and how much control you wish to retain.

Selecting the right approach involves considering both the potential tax savings and the practical consequences of transferring assets into trust.

A trust that offers attractive tax benefits may not be appropriate if it restricts access to money that could be needed later in life.

Important Considerations Before Establishing a Trust

Although trusts offer several potential benefits, they require careful planning.

The seven-year rule

Many gifts can become exempt from IHT if the donor survives for seven years. However, the treatment depends on the type of gift and trust.

Taper relief may reduce tax on certain gifts where death occurs between three and seven years after the transfer, but it does not reduce the value of the gift itself.

Giving away control

Once assets have been placed into certain trusts, the settlor may no longer be able to access or control them.

This can have significant implications for retirement planning, future care costs and financial flexibility.

Tax charges and administration

Trusts may incur Income Tax, Capital Gains Tax or Inheritance Tax liabilities.

Trustees may also be responsible for record-keeping, tax returns and registration with HMRC’s Trust Registration Service, subject to applicable exclusions.

Professional fees and ongoing administration costs should therefore be considered alongside any potential tax advantages.

Pension and retirement planning

Estate planning should not be considered separately from retirement planning.

From 6 April 2027, most unused pension funds and pension death benefits will fall within the scope of Inheritance Tax following changes introduced under the Finance Act 2026, although certain benefits remain excluded.

This makes reviewing pension arrangements, beneficiary nominations and wider estate planning particularly important.

Gifts with reservation of benefit

Simply transferring an asset into trust does not necessarily remove it from your estate.

For example, transferring a property into trust while continuing to live there rent-free may result in the property remaining within your estate for IHT purposes.

Understanding these rules is essential to avoiding ineffective estate planning arrangements.

How Can an Independent Financial Adviser Help?

Inheritance Tax planning involves more than simply selecting a trust.

A financial adviser can help assess the overall value of your estate, identify potential tax liabilities and consider how different planning strategies could affect your long-term financial security.

Working with an independent adviser also allows you to consider a broad range of financial products and estate planning solutions rather than being restricted to a single provider’s offering.

An experienced financial advisor can help compare trust arrangements, understand investment and advice fees, and determine how the options fit alongside your wider financial plan.

Importantly, effective estate planning should also involve appropriately qualified legal and tax professionals, particularly where complex trusts or significant assets are involved.

If you are looking to find a financial adviser who can provide a comprehensive estate planning service, consider someone who will assess your retirement needs, family circumstances and long-term objectives before recommending any particular arrangement.

Final Thoughts: Protecting Your Wealth for Future Generations

Trusts can be valuable tools for managing wealth, protecting beneficiaries and potentially reducing Inheritance Tax liabilities.

However, their effectiveness depends on selecting the right structure and ensuring it is implemented correctly.

For some families, straightforward gifting through a bare trust may be sufficient. Others may benefit from the flexibility of a discretionary trust, the financial support provided by an interest in possession trust, or specialist arrangements such as discounted gift and loan trusts.

The key is to balance tax efficiency with financial security, access to capital and the needs of future generations.

Book a meeting with an adviser to review your existing arrangements, understand your potential Inheritance Tax exposure and explore how trusts could support your long-term estate planning objectives.

Important information: This article is for general information only and does not constitute personalised financial, legal or tax advice. Trust taxation is complex and depends on individual circumstances, the terms of the trust and applicable legislation. Tax rules and reliefs may change. The value of investments can fall as well as rise, and you may get back less than you invest. Professional legal and tax advice should be obtained before establishing or amending a trust.