Peter McGahan: What is a loan trust for inheritance tax?
In between times I’ve had a few more inheritance tax queries - one of which was how to freeze the value of an estate to stop an inheritance tax problem becoming worse as stock markets and house prices soar.
Inheritance tax is that hefty 40 per cent slice taken off a part of your estate after the relevant allowances are taken into account. It’s not overly popular, particularly when you compare it to a nice glass of wine, or holiday for example.
One obvious choice is to give away our excess income each year as this falls within gifts out of normal expenditure. If you have excess income, you can make a gift from this as long as it is intended to be regular and the transferor is left with enough income to maintain their normal standard of living. Moreover, you have the benefit of witnessing the children benefitting from the gift. Nice fuzzy feeling.
For larger sums, or even the above idea, there is the risk of the children marrying someone that you just don’t trust. You know the feeling.
There are many options available but one reader has asked about a loan trust so I will cover that.
Don’t be fazed by the word ‘trust’. It’s just a legal document and used by many in pursuit of mitigating both Inheritance Tax and speedy access to capital in the event of death.
A loan trust would normally be used for people who initially want to begin Inheritance Tax Planning, but are afraid, or not ready to give away capital, and still want to retain a bit of an income from it.
How does a loan trust work? Firstly, you use an independent financial adviser, solicitor, or accountant to set up a trust for you. You then lend money to the trust and appoint your trustees (your advisers do all this for you). The trustees (people you appoint who will make sure the trust is acted on appropriately) now invest that money according to your wishes and for the ultimate benefit of the beneficiaries (who you want the money to go to).
You can then set up a loan repayment from the trust at say five per cent tax deferred withdrawal and that is paid to you. All growth on the fund is, however, outside the estate, so if the fund chosen by the trustees has performed well this does not form part of the estate at all, capping all future growth.
As you take an ‘income’ (your loan repayments) from the trust, as per the loan agreement and spend it, this capital falls out of your estate. If you decide to take the whole loan back at any time, you can do so, leaving the growth behind for the beneficiaries.
You can set up two types of trusts: an absolute trust and a discretionary trust.
With an absolute trust, you state the beneficiaries and their entitlement at the beginning and cannot change them. Beneficiaries of an absolute trust can, after age 21, demand access to the value of the growth part of the fund.
With a discretionary trust, the settlor (person who sets up the trust) can change the beneficiaries at any time, and, what they are entitled to (see dodgy boyfriend point above). Under a discretionary trust, however, there could be an ongoing tax charge. On the 10th anniversary, if the trust’s value is more than the nil rate band at the time (currently £325,000), a periodic charge will be payable.
Downsides? When you repay the loan – that’s 20 years if you are taking 5 per cent - there are no more benefits to you as the loan has been repaid. Of course, you also don’t have access to the growth but that was the point – to freeze that part of your estate.
Be careful who invests the underlying capital. Setting up a trust is easy, but the difference in costs and performance in the underlying money can be washed away in a few years if you do not have a quality manager looking after your money.
Peter McGahan is chief executive of independent financial adviser Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority. If you have any inheritance tax queries, call Darren McKeever on 028 6863 2692, email email@example.com or visit wwfp.net.