With the IHT efficiencies of pensions improving following the pension freedoms, many people may benefit from preserving their pension fund and use their other assets and investments to help fund their retirement. Whilst the state pension can provide an income, for many it will not be enough to maintain their standard of living after retirement and they will need to supplement this.
Many clients will have accumulated wealth by the time they approach retirement. This wealth could be in property, such as their main residence, in pensions whether defined benefit or defined contribution, or in an investment portfolio made up of ISAs and other collectives. These may not be IHT-efficient and, whilst business relief portfolios can help mitigate IHT, it is not always desirable to take a portfolio built up over a lifetime and increase the risk profile, particularly when clients are in the wealth preservation or decumulation stage of life. For many this is when they should be consolidating risk.
A discounted gift trust allows an individual, married couple or civil partners to invest a lump sum whilst retaining the right to fixed regular payments, designed to continue for their lifetime. They can provide valuable income tax and inheritance tax benefits, whilst allowing the trustees to invest the money in a variety of different ways.
When setting up a discounted gift trust the client, who becomes the settlor, invests in an investment bond and specifies the fixed regular payments they want to receive from the bond. These are usually expressed as a percentage of the money being invested and are carved-out and held on a bare trust for the settlor; so if any payments fall due and the settlor is alive, the payment is theirs.
As the settlor is gifting a lump sum of capital to a trust and retaining the right to the series of regular payments the amount gifted for IHT purposes is reduced, or ‘discounted’. They are not giving away the regular payments, these are being retained and these will have a capital value.
The discount is outside the settlor’s estate immediately as they are effectively exchanging part of the capital lump sum for the series of regular payments. This series of regular payments ceases on death and hence, on the death of the settlor has no value. The excess over the discount is a gift for inheritance tax purposes and will be a chargeable lifetime transfer or potentially exempt transfer depending on the type of trust being used and have a seven-year clock running before it is outside of their inheritance tax calculation.
In order to value the rights that are being retained by the settlor the product provider needs to establish the life expectancy of the settlor. The longer the life expectancy, the longer the payments are expected to be made for and therefore the greater the capital value of the payments and discount. A shorter life expectancy means that fewer payments could be made and therefore the capital value of those payments, and the discount, will be lower.
The underwriting is generally expressed in the form of added years; if the settlor has health issues the provider may treat them as being older than they actually are. HMRC will not allow anyone with an actual or assumed age of over 90 to benefit from a discount. This does not mean a DGT is unsuitable, just that they will not benefit from a discount – they could still benefit from tax deferred payments and have the money outside of their estate after seven years.
The underwriting decision from different providers may vary but the basis for the discount calculation and the assumptions that should be used are set by HMRC. Straying from these assumptions or being too lenient with the underwriting decision could provide a discount that HMRC believe is too generous. For example guidance from HMRC (HMRC Brief 22/13, section 2.3) states that if the tax deferred allowance from the bond has been exceeded the discount should be based on the settlor being a higher rate taxpayer. Some providers may assume them to be non-taxpayers, inflating the discount. It may be more attractive but could be challenged by HMRC.
Income tax efficiency
The use of an investment bond allows for the fixed regular payments to make use of the tax deferred allowance available under chargeable events legislation.
Using an investment bond to hold the money allows up to 5% of the amount invested to be paid as a withdrawal, or partial surrender, without any immediate income tax liability.
The payments made to the settlor under a discounted gift trust make use of this facility, as do any ongoing adviser charges. Providing they remain within this allowance these payments do not attract any immediate income tax charge on the settlor or the trustees. From the settlor’s perspective, and comparing it to other types of investments, the payments can be received without any deduction of tax.
If the withdrawals continue long enough to fully utilise the tax deferred allowance then subsequent payments will be treated as chargeable gains and potentially be taxable. Whether any tax is payable will depend on the settlor’s tax position and whether the bond is issued by a UK or international provider. For example, if using a UK bond the gain carries a basic rate tax credit and therefore tax would only be payable if this made the settlor a higher rate taxpayer.
The use of a bond does mean that, at some point, it will come to an end. This could be if the bond is surrendered on the death of the last life assured, if using a life assurance bond, or on the maturity of a capital redemption bond. In many instances the trustees could distribute the trust assets before this time and the ability to assign a policy out to a beneficiary means that the tax point moves to them, potentially reducing the tax payable.
A bond allows access to a wide variety of investment choices. Many bonds from UK providers will allow access to a fettered range of funds selected from mainstream fund management companies and include multi-asset, risk profiled and risk managed solutions. These could be suitable for many investors but if a greater range of investment solutions is desired, maybe for larger investments, an international provider can allow much more investment flexibility, such as investment platforms and discretionary investment managers. The flexibility of an international bond can allow access to multiple platforms and discretionary fund managers (DFMs) and allow clients to switch between the different solutions within the same product. Some, such as Canada Life, will even allow a facility to invest outside of the normal range of permissible assets, giving a DFM the opportunity to have wider discretionary powers and the ability to use direct holdings when constructing a portfolio.
Ultimately the investments employed will depend on the adviser firm’s investment proposition and what is suitable for the settlor and the trustees given their risk profile and capacity for loss. Effective risk management can help preserve the money in the trust despite the withdrawals, and even provide an element of growth on the money passing to the beneficiaries. This can help cascade wealth.
Trusts have been in use in the UK for hundreds of years and are firmly enshrined in legislation. Using the carved-out benefits of a discounted gift trust can help supplement retirement income and, as the amounts payable are fixed, can be beneficial for a settlor, allowing them to budget. They know what money they are going to receive and although the payments could stop if the trust runs out of money, this can be minimised by effective investment management.
If flexible payments are required then a flexible reversionary trust can also be a retirement supplement and this trades the income tax efficiency for flexibility. For the right client a combination of trusts can help with the construction of a retirement strategy, allowing them to maximise the money they pass on to future generations.
When considering retirement, the use of pensions has changed over the last few years and advisers and their clients should not limit themselves to pensions for retirement, but look at other assets the client owns. The use of trusts can make part of a portfolio more tax efficient without increasing the risk the money is exposed to, whilst providing the level of access a client desires.
Neil Jones, Market Development Manager.
Neil is an investment specialist with over 20 years’ financial services experience with life and pensions providers, an investment company and as a professional adviser specialising in pensions, investments and estate planning. Neil has been involved in product development, investment research and training.