Trusts & Wills – Frequently Asked Questions following the Budget and Finance Bill (7/5/2006)

The Chancellor's tax attack on trusts has left millions wondering whether they need to rewrite their wills. Following the publication of the Finance Bill last week, Money Mail examines the implications.

What is a trust?

A trust allows you to pass money to your heirs while protecting it from tax and keeping some control over how the money is used. The 'giftor' can impose restrictions, such as when the money is released and how it can be spent.

Why set one up?

First and foremost, to ensure your heirs receive the maximum amount of money free from inheritance tax (IHT). This is charged at 40% on all assets in an estate above a nil-rate band, which currently stands at £300,000.

So a £500,000 estate would face inheritance tax on the top £200,000; at 40% this would mean an £80,000 bill. A couple could avoid this by setting up a nil-rate band trust which would take £300,000 when the first of them dies. The surviving spouse could take an income from that trust but it would not form part of their estate. When the second person dies, the proceeds of the trust are distributed to their children and they avoid IHT.

Are there any other reasons for doing it?

Yes, to control how money is spent and when your heirs receive it.

For instance, an accumulation and maintenance (A&M) trust is often used by grandparents to pay school fees for their grandchildren. When the children turn 25, they inherit any remaining capital and, as long as the grandparents have lived for seven years since setting up the trust, there is no IHT to pay.

Parents might set up trusts in their wills to ensure their children are cared for if both parents die. They could stipulate who has control over the money, what it can be used for and when it is paid out. Commonly, it might be held in trust until the offspring are 25.

Another situation involves an interest-in-possession trust. This might allow a widow to draw an income from money in the trust, but the capital goes to the children when she dies. It could be used by someone who has married for a second time and wants his second wife to be financially secure while ensuring the children of his first marriage eventually inherit.

What changed in the Budget?

Some trusts have been hit by a new tax charge. Anything put into an A&M trust over the nil-rate band of £300,000 during your lifetime is subject to a 20% IHT charge. Then there is a further charge of up to 6% on everything over the nil-rate band every 10 years, and another tax charge of up to 6% on everything over the nil-rate band when the trust finally pays out.

These charges can be avoided if the money goes into a bare trust, which means the children have to get it at 18.

Interest-in-possession trusts could be hit by a 40% inheritance tax on everything over the nil-rate band when the money goes in, even if it's for your spouse, plus a further charge of up to 6% every 10 years, according to the Society of Trust and Estate Practitioners (Step).

This is the first time for more than 30 years that transfers between spouses can be affected. These taxes can be avoided only under very strict conditions, and trust experts are lobbying hard against these rule changes.

Who will be affected?

The Treasury says just 20,000 people will be affected. But insurers, solicitors and accountants claim millions could be hit. The scenario which might worry most people is that if both parents die, their children will have to inherit when they are 18 rather than the money being locked away until they reach 25.

Can we avoid the new taxes?

Not really. You could change the terms of a trust before April 2008 to allow children to inherit when they are 18. Grandparents considering setting up A&M trusts could put off the pain by moving only £300,000 into the trust to avoid the living IHT charge. That would be £600,000 for a couple.

How will life insurance policies be affected?

Life insurance policies have commonly been written in trust. Basically this means that when, for instance, a parent dies, the money can go to their children without IHT being charged.

If you put a new life policy into trust now, you could be hit by three taxes - one on the premiums paid, a second every 10 years and a third when the trust pays out. However, this is only likely to happen in exceptional circumstances.

If you are well, the insurance policy is valueless as it's unlikely to have to pay out. But if you are terminally ill, the policy will have some value and you could be taxed at 6% on everything over your nil-rate band of £300,000. This point is still open to interpretation and industry groups are lobbying the Government on the issue.

When the policy pays out on your death, there can be an exit charge of up to 6% on proceeds over the nil-rate band. If your policy is worth less than the nil-rate band, there is no tax to pay at any stage as long as it is written in trust.

We have nil-rate band discretionary trusts set up in our wills. Will we have to change them?

No, these have not been affected.

If we both die, we don't want our children to be able to spend their inheritance until they are 25. Is this still possible?

If you have willed your children's inheritance to a discretionary trust, typically an A&M trust, you'll either have to change it so that they get the money at 18 without paying tax, or accept that they'll have to pay tax at up to 6% on the amount over the nil-rate band when they receive the money at 25. There will also be a tax charge on the tenth anniversary of the trust.

We have set up a trust to pay our grandchildren's school and university fees. Do the new rules mean they can spend the money on fast cars when they are 18?

The previous answer applies because this is an A&M trust. In addition, those considering setting up new trusts would have to pay a living IHT charge of 20% on anything that goes in over the nil-rate band of £300,000 (or £600,000 for a couple).

My life insurance is written in trust to pay out to my children when I die. Will this now be taxed?

No, it shouldn't be as only new trusts will be caught, but the guidelines are still being clarified.

My company pays out a tax-free lump sum to my widow and children if I die. Will this be hit?

HM Revenue & Customs says death-in- service benefits will remain tax-free, provided they're paid directly to your beneficiaries rather than into your estate.

Who should consider writing a new will?

Everyone who does not have a Will or whose estate has altered or increased since their last Will was written. Additionally, anyone who has a Will leaving their assets to a trust should have their Wills re-written; apart from those with a nil-rate band discretionary trust.

How do I write a new will?

Candour Consultancy employs a lawyer who charges between £500 and £750 for Will writing; depending on how complex the Will is. Avoid do-it-yourself kits - they may save you a few pounds now, but could cost your heirs tens of thousands if you get it wrong.

Take advantage of our wealth management package where we use professionals to structure your estate tax-efficiently and we pay to have your Wills re-written.