What is a discretionary trust?

23 Apr 2024 | Jenny Walsh
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With a discretionary trust, there is no automatic right for beneficiaries to receive funds from the trust. Instead, the trustees are given broad powers to decide how and when the money is distributed, making them one of the most flexible forms of trust available.

A discretionary trust enables trustees to allocate income and capital from the trust entirely at their discretion. They can decide who should benefit from the trust, when and in what proportion. This means there’s much more flexibility and funds can be paid out or withheld as circumstances change.

How do discretionary trusts work?

A common way to set up a discretionary trust is in a will but you can also set one up during your lifetime. With this type of trust, money and assets are placed into the trust for the benefit of the trust’s beneficiaries. Beneficiaries can be named individuals or they can be groups of individuals, such as “my grandchildren.” They can also include people who are not born yet. For example, “my grandchildren” could include all the grandchildren that may be born in the future.

What’s unique about discretionary trusts is that the beneficiaries are classified only as potential beneficiaries. They do not become actual beneficiaries until the trustees decide to pass funds to them. The trustees can decide which of the beneficiaries receive a distribution, how much they receive and when they receive it. It’s important that trustees are people you trust, as you essentially hand all decisions over to them.

What are the benefits of discretionary trusts?

Discretionary trusts can sound strange on the face of it but there are many reasons why they may be an important part of your estate planning.

  • For one, discretionary trusts can be used to manage wealth across multiple generations. You can name grandchildren and their descendants as beneficiaries, for example, even though most of those people are not born yet.
  • Second, a discretionary trust can protect vulnerable beneficiaries, such as adult children with learning difficulties who may not be able to manage money on their own.
  • Third, a discretionary trust can ensure that a beneficiary in receipt of means-tested benefits receives funds in smaller amounts over time. That way, they do not lose these benefits as they would if they inherited a lump sum of money.
  • Finally, a discretionary trust is extremely useful if you would rather take a “wait and see” approach than fix the inheritance at the time of your death. By leaving things in the hands of trustees, you can make sure that money is distributed according to who needs it more. For example, the trustees could release money if a beneficiary wishes to buy a property. Or they could withhold funds until a beneficiary with a gambling habit has addressed their addiction. The trustees can decide what is best for the beneficiaries in each case.

What is a letter of wishes for discretionary trusts?

Since the trustees have a lot of power, you may want to give some guidelines for them to follow. This can be achieved by leaving a letter of wishes along with your will, setting out the circumstances in which you would like your beneficiaries to receive their assets.

The trustees are not bound by a letter of wishes, but they can take it into account when managing the estate.

How are discretionary trusts taxed?

When a discretionary trust is created, the transfer of assets into the trust is subject to an immediate assessment to Inheritance Tax (IHT). If the value of the assets exceeds the IHT nil rate band (currently £325,000), there will be an immediate tax charge, although it may be possible to claim reliefs. Discretionary trusts are also subject to a periodic charge to Inheritance Tax every 10 years at 6% of the trust’s value over the nil rate band.

A discretionary trust will also pay income tax at the highest rate. Currently, any gross income above £1,000 at 45% or 39.35% for dividends. The trustees will need to make annual income tax returns every year.

Is a discretionary trust right for me?

Discretionary trusts can be beneficial for both beneficiaries and asset protection, but it’s important to weigh up the tax implications and the more extensive trust administration responsibilities. The key issue is to seek expert advice and make sure that a discretionary trust is the best vehicle for supporting your loved ones as part of your long-term tax and estate planning.

How we can help

Set up a discretionary trust today to protect your assets and ensure your loved ones are cared for according to your wishes. Contact us now to get started. Call 020 7485 8811 or fill in the contact form below.

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