What is a discretionary trust?

This type of trust gives trustees the discretion to decide how and when to distribute funds to beneficiaries. They are commonly used for estate planning as they can help to protect assets and prevent them from being spent too quickly. This guide provides a complete definition of discretionary trusts, looking at their pros and cons and all the taxes involved.

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A discretionary trust can be defined as a type of trust where the trustees have the power to decide how to use the trust’s assets for the beneficiaries. The trust will not pay out fixed amounts of money for these beneficiaries at a predetermined time. Instead, this decision is at the discretion of the trustee, who can choose when and how much money (if anything) to pay out.

When you (the settlor) set up a discretionary trust, you choose a group of potential beneficiaries, such as family members, who you’d like to receive money from the trust. Beneficiaries aren’t guaranteed to get anything, however, as the trustees have the final say on how the income from the trust and its contents get distributed.

You can set up a discretionary trust during your lifetime or include it in your will so that it takes effect after your death. You may hear these trusts defined as ‘discretionary settlement trusts’, which is what they are called during the setup process. Another name is ‘discretionary family trusts’, as they’re often used to continue providing for children or grandchildren after the settlor has passed away.

A discretionary trust fund might hold any of the following:

• Cash or savings account balances
• Investments such as stocks, shares, or bonds
• Property. Income from rentals or property sales can be used for the beneficiaries.
• Life insurance policies
• A family business, or shares in it

There are a few different parties that make up a discretionary trust in the UK. These include:

• Settlor – The one who sets up the trust and chooses the trustees and beneficiaries. Instead of keeping assets or other property in their own name, they place it into the trust.
• Trustees – A group of trusted individuals chosen by the settlor. They take responsibility for the day-to-day management of the trust.
• Beneficiaries – The people who could receive money from the trust in the future.
• Appointer – Appointers can appoint or remove trustees. The appointer might initially be the settlor, but the role may then be passed to a professional adviser.

The trustee holds the legal title to the trust’s assets, but the beneficiaries are the actual owners. The assets are simply kept in trust for the future. In the trust deed, which is the legal document that outlines the details of the trust, the beneficiaries may be named individually or grouped by categories, such as children, grandchildren, or family members.

A discretionary trustee has been given ultimate control over the trust. The settlor can also be a trustee if they want to maintain some control. Sometimes, the settlor gives guidance to the trustee on how they would like the discretionary trust fund to be used, and this is contained in a letter of wishes. This isn’t a legally binding document, but it can be helpful for the trustee.

The trustees are responsible for managing the trust and making decisions about payments from it. With discretionary trusts, they must act in the best interests of all beneficiaries. Everything in the trust, including any income it earns, makes up the trust fund. Trustees can either pay out income or capital to beneficiaries or reinvest it in the trust.

You might associate trusts in general with the ultra-wealthy, but discretionary trusts can be a practical way to support loved ones financially. The beneficiaries tend to be individuals who are unable to manage money themselves due to different reasons.

The most common reasons to open a discretionary trust include:

• Providing for children or grandchildren in the future
• Supporting a family member with a disability or illness affecting their ability to handle finances
• Protecting assets for someone at risk of making poor financial decisions due to external influences or addiction
• Donating to a charity or organisation

Yes, there are a few different taxes to keep in mind if you’re thinking about setting up a discretionary trust in the UK. The main three are income tax, capital gains tax, and inheritance tax.

The trustees pay income tax on trust income at 45% (or 39.35% for dividends) before passing any income to the beneficiaries of a discretionary trust, meaning the income is already taxed before it reaches the beneficiary.

The beneficiary may then be able to claim a tax refund if their income tax rate is lower than 45%. This wouldn’t include additional rate taxpayers, as their rate is already 45%.

Claims for a tax refund may be made by the following beneficiaries:

• If their tax rate is 20% or 40%, they may be able to reclaim some of the tax that has already been paid.
• If the beneficiary is exempt from paying income tax, they could reclaim the full 45% tax credit.

In some cases, the beneficiary’s total income (including that distributed to them from the trust) falls within their personal allowance for the tax year, in which case they wouldn’t have to pay income tax.

When assets are put into a trust, the person transferring the asset may owe capital gains tax (CGT) on any profit. When assets are taken out (for example, if the trustee sells a property) the gains are calculated in the same way as for an individual and the CGT rate is 24% on all assets.

There are some reliefs available to lower the CGT burden. Trustees don’t pay capital gains tax on UK property sales if the property was the main residence for someone living there under the trust. It’s also worth noting that trustees only owe CGT if the total taxable gain exceeds the trust’s tax-free allowance, which is £1,500 for most trusts and £3,000 if the beneficiary is vulnerable.

When you place money or assets into a discretionary trust in the UK, these are treated as ‘chargeable lifetime transfers’, unless the gift falls into a specific exempt category. If the total of all such transfers (including those made in the past seven years) exceeds the nil-rate band, which is £325,000 for the 2024/25 tax year, inheritance tax may apply.

The amount due depends on who pays the inheritance tax:

• The trustees of the trust will need to pay 20% inheritance tax on the excess amount.
• If the settlor pays the tax, it’s 25%.

Discretionary trusts may also face another inheritance tax charge at ten-year intervals. If tax is due, the maximum rate is 6% on the value of the trust above the nil-rate band. There may also be exit charges if assets are distributed from the trust, again applied on any value above the nil-rate band.

Given the complexity of these tax rules, it might be helpful to consult a financial adviser who specialises in trusts and tax planning.

One of the key advantages is the power given to the trustee to decide when and how to distribute income in the best interests of the beneficiaries. Compared to some other trust types, however, discretionary trusts in the UK have some of the most complex taxation rules.

Pros:

• Flexibility: Trustees can adjust what beneficiaries receive based on their needs.
• Tax benefits: Often used as an effective form of wealth transfer, as it can reduce inheritance tax and preserve state benefits for beneficiaries.
• Inheritance planning: May be useful for passing on property with potential tax reliefs, including extra inheritance tax allowances.

Cons:

• Potential fees: The costs of possible legal or financial advice can mount up.
• Trustee responsibilities: Trustees have significant duties, which can lead to complications and potential disputes among family members.
• Tax complexity: The tax treatment of discretionary trusts can be complex, and there may be additional unexpected costs.

If you simply want to grow your savings as a way to pass on more to your children or loved ones, you might explore high-interest savings accounts. These options not only offer a secure place to hold funds but also ensure the money in the trust works harder.

If you want to quickly and easily open a savings account with competitive rates, register for a Raisin UK Account and apply today.