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Why Set Up a Discretionary Trust

Retirement planning is mostly about ensuring you have enough income to meet your financial expenses once you stop working. But there is also that irritating little detail called death. What happens to any remaining income and assets you have at the time of your passing can be as important to your survivors as retirement income is to you. If you believe you will have a sizeable estate remaining at the time of your death, one way to make sure it gets passed on according to your wishes is to establish a discretionary trust.

A discretionary trust is just one of many different kinds of trusts a person can establish to protect his or her assets from inheritance taxes and squandering by beneficiaries. Other types of trusts that are similar in nature include bare trusts, interest in possession trusts, accumulation trusts, and mixed trusts. You should definitely speak to a solicitor if you are interested in setting up some kind of trust for your estate.

How the Discretionary Trust Works

A discretionary trust is a legal entity into which you place ownership of certain assets with the understanding that they will be dispersed to your beneficiaries according to your wishes. You can place virtually any kind of assets into a trust including cash, property, securities, etc. In every discretionary trust there are three parties:

  • Settlor – The settlor is the individual who establishes the trust. This is the person who physically owns the assets that will be placed in trust.
  • Trustees – The trustees are those legally assigned ownership of the assets once transferred. They have a legal obligation to manage the trust and disburse assets according to the wishes of the settlor. There must always be at least one trustee at all times.
  • Beneficiaries – The beneficiaries are those who will receive the benefits of the trust as it is managed by trustees. The settler can name as many beneficiaries as he or she wants; beneficiaries can be individuals, groups of people, charities, or other organisations.

To establish a legal trust, a person must create two documents known as the 'trust deed' and 'letter of wishes'. The trust deed is a legal instrument that does several things:

  • Establishes the assets to be transferred into the trust
  • Provides a legal instrument to complete the transfer
  • Names the trustees; establishes a means of replacing trustees when necessary
  • Sets out conditions defining what trustees can and cannot do
  • Creates a method of dispersing all remaining assets at the conclusion of the trust period.

A trust deed is essentially the legal document that establishes the trust and gives its trustees legal authority. The letter of wishes is slightly different. It outlines details of how the settlor wants assets to be used upon his or her passing. For example, an individual may want a certain percentage of trust earnings to go to cancer research. That would be included in the letter of wishes. It is still up to trustees to decide how much will go to research and what entities will actually receive it. It should be noted that trustees are not legally bound by the letter of wishes.

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Upon execution of the trust deed, the assets placed in trust immediately become the property of the trust. The settlor, if still alive, no longer has any legal ownership of, or interest in, the transferred assets.

Who Would Set Up a Discretionary Trust

Although it may seem like a discretionary trust is relatively restrictive, it is actually the most flexible of all the trust options. The individual who most benefits from the trust is the settlor him/herself, in that the formation of a trust gives him or her maximum control over what happens with assets after death. It enables a person to pass on a rather sizeable estate without having to worry about excess taxation. We will look at taxes a bit more later in this guide.

Why would a person set up a discretionary trust? Here are the most common scenarios:

  • Asset Protection – Individuals of high net worth frequently use discretionary trusts to protect their assets from taxation. There is no point in allowing the taxman to decimate your assets upon your death when those assets could be used to help other people.
  • Family Provision – Some people choose to set up a discretionary trust to ensure a surviving spouse is provided for until death. It might also be used to pass assets onto the children who, because of their age or station in life, may not be able to properly manage the assets on their own.
  • Educational Expenses – It is not uncommon for people to establish discretionary trusts in order to provide for the education of children or grandchildren. Assets are used to cover the cost of attending university.
  • Disability Provision – It is also not uncommon to use a discretionary trust to make sure a disabled family member or friend is well cared for after one's death.
  • Philanthropy – A person may transfer assets into a discretionary trust in order to carry on philanthropic work after death. The settler can engage in that philanthropy even while still alive, with cooperation from trustees.

At the end of the day, the most common purpose for setting up a discretionary trust is to help young or incapacitated people who could really benefit from the assets but who do not have the ability to manage them by themselves. Examples would include grandchildren, great-grandchildren, and family members or friends who may suffer from a mental or physical disability.

Taxes and Discretionary Trust

As you may have guessed, a discretionary trust is not 100% tax-free. Nothing ever is. The benefit of setting up such a trust is one of avoiding excessive inheritance tax when you die. But there are still taxes to be paid. In this section, we will give you the basics of taxation relating to trusts. However, this is a very complicated area of financial management. It is essential to consult with a tax attorney and financial planner regarding trust taxation.

The first tax to consider is income tax on any earnings the trust realises. In other words, assume you are putting property and securities in trust for your future grandchildren. Those assets will earn money over time. All earnings are subject to income tax under one of the following rates:

  • basic rate
  • dividend ordinary rate
  • dividend trust rate
  • trust rate
  • standard rate band.

Next, there is a tax levied on your assets when you establish your trust. This is commonly referred to as the 'set up tax'; it is an advanced inheritance tax for all intents and purposes. It is not levied on assets of less than £285,000 per settlor. Anything more than that amount incurs a 20% income tax and no capital gains on cash. Any non-cash assets will be subject to capital gains.

Every ten years, the trust must pay a 6% capital gains tax on any amounts contributed over the £285,000. Also, any earnings the trust makes during that period are subject to 40% capital gains tax. Beneficiaries do not pay capital gains taxes individually as they are the responsibility of the trust and its trustees.

Lastly, there may be some inheritance taxes involved when the trust is eventually wound up and any remaining assets distributed. Such taxes would be applied according to beneficiaries, how much they receive, and other factors that are too complicated to get into here.

A discretionary trust is a legal instrument that allows an individual to control how his or her estate is used upon his/her passing. It is something you might want to look into if you know you will have a sizeable estate to deal with upon your death. You can use your assets to benefit your family, a particular group of people or charity, or any other beneficiaries you believe are deserving of those assets you plan to leave behind.

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