Discounted gift trusts (DGTs) are a long‑established estate planning tool, yet they’re often misunderstood or used cautiously because of their technical nuances. In their latest article, the Quilter bring some clarity in what DGTs are, and how they can be used.
By combining an inheritance tax (IHT)‑efficient gift with a retained right to income for life, DGTs can offer a compelling solution for clients who want to reduce their taxable estate without giving up financial security.
This article revisits how DGTs work in practice, where the IHT ‘discount’ comes from, and the key considerations for advisers when assessing whether they’re appropriate for a client’s wider planning objectives.
How discounted gift trusts work
A discounted gift trust (DGT) lets your client (the settlor) make an inheritance tax (IHT) efficient gift that can fall outside their estate after seven years, while keeping a lifetime right to regular withdrawals from the trust.
The retained right to withdrawals can add a further IHT benefit. HMRC accept that the value of the gift is reduced (discounted) by the market value of that right, based on the settlor’s age and health.
The retained right is also treated as outside the estate straightaway, creating the potential for an immediate IHT saving.
Predictable, tax-deferred withdrawals
The settlor sets the amount and frequency of withdrawals in the trust deed. Payments continue until the settlor dies or the trust fund runs out, if sooner.
For joint-settlor DGTs, withdrawals typically continue at the same level until second death, although this can vary between trusts.
DGTs usually hold an investment bond, allowing tax-deferred withdrawals of up to 5% of the premiums paid each year.
This can provide regular payments to the settlor for up to 20 years without an immediate tax liability.
Making sense of the discount
The discount arises from the settlor’s retained right to receive fixed withdrawals for life.
Although the settlor makes a gift, HMRC accept that the retained right has value, so the value of the gift is reduced by that amount.
The discount must be established before the trust starts. The bond provider will usually request a medical report from the settlor’s GP and calculate the discount using actuarial assumptions set out in HMRC guidance.
Broadly, this estimates what someone would pay on the open market to acquire the right to the settlor’s withdrawals.
Although it can feel counterintuitive, the retained right is treated as having no value at death.
This is because withdrawals are fixed, cannot be increased or brought forward, and stop immediately on death.
As a result, they’re deemed to have no value in the settlor’s estate on the date of death, which is why an immediate IHT saving can arise.
Important: any discount calculated at outset is an estimate and can be revised by HMRC if the valuation is reviewed on the settlor’s death.
Mastering the DGT
To use a DGT effectively, it’s important to understand a few key points.
Beat the nil-rate band
Discretionary trusts offer flexibility over beneficiaries, but an entry charge applies where cumulative chargeable lifetime transfers (CLTs) exceed £325,000.
Because the discount reduces the CLT value, a DGT can allow larger amounts to be settled into a discretionary trust without triggering an entry charge, increasing planning flexibility.
Balancing the discount with practicality
Higher withdrawals lead to a higher discount. While this can create an attractive headline IHT saving, withdrawals are fixed for life, so it’s important not to overdo it.
Withdrawals received by the settlor form part of their estate. If they are spent, this is not an issue.
However, if surplus withdrawals build up over time, the IHT saving can gradually unwind.
Although withdrawals can be reduced or stopped, doing so has further IHT implications. In most cases, it’s sensible to set a realistic level from the outset.
No discount?
Some clients may receive a nil or negligible discount, meaning there is no immediate IHT saving. Even so, a DGT can still play a useful role:
- the gift falls outside the estate if the settlor survives seven years
- any investment growth is outside the estate straightaway
- the settlor continues to receive their chosen withdrawals
- the settlor’s executors may still be able to agree a discount with HMRC on death
Summary
Used well, a discounted gift trust can be a powerful planning tool, combining inheritance tax efficiency with a reliable income stream for life.
As the taxation of pensions continues to evolve, trusts are likely to play a much greater role in estate planning.
For clients who want to reduce inheritance tax exposure without giving up regular income, DGTs can help bridge that gap by replicating some of the features of pension drawdown, while gradually moving wealth out of the estate.
For more information on trusts, visit quilter.com.
Main image: umberto-9z2-YNeDX-c-unsplash
