What is a discretionary trust and how is it taxed for inheritance tax purposes?

Full answer

Discretionary trusts are a flexible estate and tax planning tool, but they come with their own distinct and relatively complex Inheritance Tax regime, often called the "relevant property regime," separate from the rules that apply to outright gifts or trusts for a single named beneficiary. **What makes a trust "discretionary"** In a discretionary trust, no single beneficiary has an automatic, fixed right to trust income or capital -- instead, the trustees have discretion over which beneficiaries (from a defined class, which might include children, grandchildren, or other family members) receive distributions, and when and how much. This flexibility is useful where the settlor wants to provide for a range of family members without fixing exact entitlements decades in advance, or wants trustees to be able to respond to beneficiaries' changing circumstances (like providing more for a beneficiary who develops additional needs). **Entry charge: 20% on transfers above the Nil Rate Band** When assets are transferred INTO a discretionary trust during the settlor's lifetime, this is treated as a "chargeable lifetime transfer" -- if the value transferred (combined with any chargeable transfers made in the previous seven years) exceeds the settlor's available Nil Rate Band (£325,000 for 2026/27), an immediate lifetime IHT charge of 20% applies to the excess (this rises to an effective 40% if the settlor dies within seven years of the transfer, since the transfer is then recalculated using death rates, with credit given for the 20% already paid). **Ten-year periodic charges** Every ten years from the trust's creation, the trust is subject to a periodic charge on its value above the Nil Rate Band available at that time, at a maximum effective rate of 6% (calculated using a formula based on 30% of the lifetime rate, itself 20%) -- this is designed to prevent trusts being used to hold assets outside anyone's taxable estate indefinitely without any IHT ever being charged. **Exit charges when assets leave the trust** When assets are distributed OUT of the trust to a beneficiary (either between periodic charge dates or at any other time), an exit charge may apply, broadly proportional to the time elapsed since the last periodic charge (or since the trust's creation, if within the first ten years) and the rate that applied at the last periodic charge calculation. **Why discretionary trusts remain useful despite the tax regime** Despite the entry, periodic, and exit charges, discretionary trusts remain valuable for specific purposes: protecting assets for vulnerable beneficiaries who cannot manage money themselves, providing flexibility for future family circumstances that cannot be predicted at the time of setting up the trust, and in some cases, still achieving worthwhile Inheritance Tax savings compared with leaving assets in the settlor's estate outright, particularly where the settlor has significant assets well above the Nil Rate Band. **The £325,000 threshold applies per settlor, and can combine with the annual exemption and other reliefs** Settlors can use their £3,000 annual gift exemption and other available exemptions to reduce the value transferred into a discretionary trust before the 20% entry charge calculation, and spouses/civil partners can each use their own Nil Rate Band if setting up trusts individually, offering some planning flexibility for couples. **Trust administration and reporting** Discretionary trusts require ongoing administration -- trustees must file trust tax returns, calculate and pay any periodic and exit charges, and (since trust registration requirements were extended) register the trust with HMRC's Trust Registration Service, adding an administrative burden compared with simpler estate planning approaches. **Practical tip** Discretionary trusts involve genuinely complex, ongoing tax administration -- always take professional advice from a solicitor and/or tax adviser experienced in trust taxation before setting one up, and budget for the ongoing cost of proper trust administration, not just the upfront cost of establishing it.

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