Wednesday 15 September 2010

Discounted gift trust worthwhile?

Question
I have about £500,000 to invest and, to avoid IHT, it has been suggested that I put this into a Pru Growth Fund in a Discounted Discretionary Trust.

There is a considerable Commission payable to the Adviser but this will be paid by Pru not myself.

Do you have any views on this or alternative suggestions? Your advice will be much appreciated.Answer
There are two issues to consider here: the quality of the advice given and how much you are being charged for it.

Let's start with the latter:

Investment bonds (the type of investment being recommended here) typically pay initial commission of around 4% plus annual commission of 0.5%, or a single upfront payment of around 6%. So based on a £500,000 investment the adviser is effectively charging you around £20,000 initially plus £2,500 a year for as long as you hold the bond, or a one-off amount of about £30,000 - not bad for a few hours work...

Please don't be deceived into thinking commissions are not a fee you end up paying. Prudential may well pay the adviser directly, but the commission ultimately comes out of charges Prudential levy on the investment.

A far more cost effective route would be to find a fee-based adviser who charges either reasonable fixed or hourly fees and rebates/waives all commissions. Using this route should cut the cost for initial advice to £2-3,000 (at most) followed by a few hundred pounds a year for keeping an eye on things. And the charges you pay on the underlying investment(s) will be reduced by the amount of commission that would have otherwise been paid (or, if this isn't possible, the adviser will hand you a check for the commission received).

Now onto the advice:

There's really only one way to avoid inheritance tax (IHT) on your assets - give them away. Smaller gifts within annual allowances will fall out of your estate straight away, otherwise you'll have to live for at least seven further years until the potential IHT liability is extinguished (read more details on our inheritance tax page).

However, it's common to want to give assets away but retain some control, for example preventing grandchildren from getting their hands on them until they reach a certain age. This is where trusts come in. There are quite a few different types of trust, but fundamentally they all do the same thing: allow you to give something away while retaining some control over what happens to it - although this doesn't mean you can take it back if you subsequently change your mind!

Discounted discretionary trusts are interesting as they offer a way of shifting part of a gift outside of your estate without having to live for seven years afterwards, and receive regular withdrawals (effectively an income) from the trust for the rest of your life.

This works because the part of the gift that is earmarked to pay the withdrawals (called the 'discount') is not treated as a gift for IHT purposes, hence it reduces the size of the your estate. The size of the 'discount' increases the more you withdraw and/or the longer your life expectancy.

You need to careful that the gift (i.e. your £500,000 less the discount) does not exceed the IHT nil rate band (currently £325,000) else it'll be taxed at 20% initially followed by a further 6% tax every 10 years. This isn't a problem if you use a discounted bare trust, although you can't then change the beneficiaries at a future date.

If you die within 7 years HMRC may well investigate to make sure you weren't trying to dodge IHT (by using a discounted trust when you knew your life expectancy was very short) - the insurer offering the trust/bond will also likely request a doctor's report to ensure the discount rate is realistic.

If you're confident you'll live for at least 7 years and would like to receive an income after making the gift, you could consider a flexible reversionary trust. Unlike a discounted gift trust there's no immediate reduction in the size of your estate (you'll have to live for 7+ years), but it's possible to hold unit trusts and other investments which may be more tax efficient than investment bonds.

A big issue to consider with discounted trusts containing investment bonds is what happens when you die. It's likely to be more tax efficient for the bond(s) to be assigned to the beneficiaries (so they own them directly) and then surrendered rather than doing so in the trust in which case the tax due on the gain (which is taxed as income re: investment bonds) would be at the 50% trust income tax rate. And investing in an offshore investment bond is likely to be more tax efficient than an onshore one, as it defers basic rate tax that would otherwise be deducted as you go along.

It's also very important to pay attention to the quality of investment management and the income/capital gains tax tax implications of investments held within a trust. No point in trying to save IHT if poor investment performance and penal tax offsets the savings.

I'm afraid I can't practically cover all your options in my answer, but suffice to say good independent advice would be sensible.

Just try to find a more cost effective adviser than the one you've already spoken to - they sound like the sort of person that's given the financial advice industry such a bad reputation...

Read this Q and A at http://www.candidmoney.com/questions/question282.aspx

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