DISCRETIONARY TRUST: Definition, Advantages and Disadvantages

Discretionary trust

People are increasingly using trusts to plan for and protect their wealth. Because there are so many various methods to use trusts and so many different types, it’s critical to seek advice from a reputable financial consultant for your individual situation. This article focuses on Discretionary Trust, an example including their advantages, disadvantages, beneficiaries, and tax implications.

What is a Discretionary Trust?

It is a sort of trust that is established to benefit one or more beneficiaries. The trustee is in charge of deciding when and how much money is delivered to the beneficiaries. The beneficiaries have no say over when the funds in the trust are withdrawn. This fund is separate from the beneficiary’s assets and estate. The settlor (founder) of the trust may leave a letter of purpose to instruct the trustee regarding fund dispersal; however, this letter is not legally binding. Any attempt to circumvent the trustees’ discretion renders the trust null and void.

How Does a Discretionary Trust Work?

In most trusts, the beneficiaries are paid monthly, or the trust corpus is divided after a set period of time. In any case, the terms of asset distribution are fixed. A discretionary trust, on the other hand, has no set period or requirements. The trustee determines the payment terms, and the recipient is not permitted to claim the funds at any time. The trustee has complete authority over the fund, but they are not allowed to gain from it. A trustee has the authority to disobey the will of the settlor.

Some discretionary trusts may include an appointer to prevent this from happening. The appointer has the authority to remove a trustee and appoint a new one. Discretionary trusts are popular in the United Kingdom, Canada, and Australia. It is also known as a family trust in Australia and New Zealand. A discretionary trust can be divided into two parts. The trustees may have the authority to select a beneficiary from a specific group.

The trustees will decide how much money will be handed to the beneficiaries. The majority of discretionary trusts grant both of these powers to the trustee, however, certain trusts may revoke one of these powers. In some circumstances, the trustee chooses the beneficiary from a preset group of people, but the amount payable is fixed. A discretionary trust may also grant the trustee the authority to add or remove beneficiaries at his or her discretion. It allows for adaptability under changing circumstances.

What are the Advantages of Creating a Discretionary Trust?

Discretionary trusts can be quite beneficial in a variety of situations. They can be adjusted to meet your and your family’s needs while also benefiting your estate as a whole. They are useful for protecting assets for beneficiaries who are unable to manage their own funds. These could be:

  • Children
  • Those who are afflicted with a disease or handicap that limits their ability to work
  • Those who may make poor life choices or come into contact with improper influences or addictions

The trustees have the authority to adjust what the beneficiaries get from the trust as they see fit. Discretionary trusts can be used to keep assets out of the hands of business creditors or a divorcing spouse.

How can a Discretionary Trust aid Inheritance Tax Planning?

When it comes to passing on money to your beneficiaries, discretionary trusts can be a tax-efficient alternative, guaranteeing that:

  • They are not saddled with a hefty inheritance tax burden.
  • Their eligibility to state support or benefit, such as disability support or assistance with care home payments, is unaffected by their inheritance.

When deciding how to pass on property, discretionary trusts are also useful. They can assist you with:

  • Take advantage of inheritance tax business or agricultural benefit that would otherwise be unavailable if both you and your spouse died.
  • Put assets outside of your spouse’s control that are projected to appreciate in value and incur extra tax (for example, land with development potential)
  • By dividing ownership of your family home between a surviving spouse and a trust, you can reduce the taxable value.
  • If you or your spouse (or both) have previously been widowed, you are entitled to further inheritance tax exemptions.

You can put it up during your lifetime or include it in your Will to take effect after you die. If you create it while you’re still alive, keep in mind that it may be subject to inheritance tax if you die within 7 years. Any lifetime gift to the trust that exceeds the £325,000 inheritance tax threshold will be taxed at 20%. There may be further tax breaks available to you; we’ll be able to tell you whether this is the case.

Example of a Discretionary Trust

Frank and Mary are the parents of a small family. Frank is affluent but ailing, and he wants to make sure his children are taken care of. He is concerned that because they are young, they would lack the maturity to use the money wisely. He establishes a discretionary trust and appoints a trusted acquaintance as trustee. By doing so, he ensures that his trustee will meet his children’s requirements, and the discretionary trust ensures that they will not waste the money.

Where should Discretionary Trusts be included in your Estate Plan?

Discretionary trusts should be included in all trusts you create that will eventually be handed to your heirs, including:

  • Your Irrevocable Revocable Living Trust
  • Your Life Insurance Trust, Irrevocable
  • The Individual Retirement Account (IRA)

Who Can Be a Discretionary Trust Beneficiary?

You can make anyone a beneficiary. They could be:

  • Identified individuals
  • People in groups, such as “my grandchildren and their descendants.”
  • A charitable organization, or a group of organizations
  • Other organizations, such as businesses or sports teams

People who haven’t yet been born can be discretionary trust beneficiaries, allowing you to plan for future grandkids and other descendants.

Is it Possible for a Trustee to be a Beneficiary?

Yes, but in the interests of the trust, it’s a good idea to ensure:

  • There is no conflict of interest between a trustee’s role and a beneficiary’s status.
  • A non-beneficiary is represented by at least one trustee.

Discretionary trusts, by definition, vest a great deal of power in the trustees. As a result, it’s critical to have at least one person in charge who doesn’t have a financial stake in the trust.

What are the Disadvantages of Utilizing a Discretionary Trust?

#1. Asset management

The Settlor (the person who places assets in the trust) loses ownership of their assets when they are transferred to the trust; the assets then fall under the responsibility of the trustees, who must manage them in line with the Trust Deed. Because assets cannot generally be given back to the settlor, it is critical that you are certain how to proceed before establishing a trust.

#2. Administrative burden

Setting up a Discretionary Trust might be complicated, but sustaining such a trust on an ongoing basis can add administrative complexity and cost. Trustees should meet on a regular basis, and yearly accounts and tax filings may be required. Trustees may also need to seek further legal, accounting, or financial counsel.

Tax and Discretionary Trust

When contemplating the usage of a Discretionary Trust, it is critical to understand the tax issues that may apply to you, such as Inheritance Tax, Income Tax, and Capital Gains Tax.

#1. The inheritance tax

Discretionary Trusts fall under what is known as “the relevant property system,” which means they are liable to inheritance tax, which might complicate matters.

If a donation into a Discretionary Trust arrangement does not fall into one of the exempt gift categories, it is classified as a Chargeable Lifetime Transfer (CLT), which means it is immediately chargeable to inheritance tax.

When these gifts are joined to any other CLTs made within the last 7 years, if the total value exceeds the Nil Rate Band (currently £325,000 for the 2021/22 tax year), inheritance tax will be charged on the excess. This charge is 20% if paid by the trustees or 25% if paid by the settlor.

For example, if you gave £400,000 to a Discretionary Trust and had made no other CLTs in the previous 7 years, there would be an upfront charge of 20% on £75,000, which would equate to £15,000 that the trustees would pay.

An additional inheritance tax charge assessment that must be performed on the trust’s ten-year anniversary can add to the complexity. If tax is owed, the maximum rate is 6% of the trust value in excess of the Nil Rate Band. When the value of the capital distributed out of the trust exceeds the Nil Rate Band, there may be time-apportioned ‘exit’ costs.

For instance, Judith decides to put £325,000 in a discretionary trust for the benefit of her children. In the last seven years, Judith has made no other gifts or transfers. Because the amount falls inside the Nil Rate Band, there is no immediate charge to inheritance tax. The money has been invested for ten years and is now worth £500,000. Assuming the Nil Rate Band remains at £325,000, an inheritance tax levy of £10,500 would apply.

#2. Tax on earnings

Trustees are personally liable for paying taxes on income received from a Discretionary Trust. Once the regular rate band of £1,000 is exceeded, income within the trust is charged at an extra rate of 45 percent (38.1 percent for dividend income). Income in this range is taxed at the standard rate of 20%. (7.5 percent for dividend income). Any income provided to beneficiaries is accompanied by a 45 percent tax credit, thus some or all of it may be available for tax reclaim by the beneficiary.

#3. Capital Gains Tax

If trustees sell or transfer assets on behalf of the beneficiary, they may be required to pay Capital Gains Tax. Discretionary Trusts, like individuals, get a yearly exemption from Capital Gains Tax, however this is capped at £6,150 (for the 2021/22 tax year). Capital gains in excess of the trust’s yearly exemption are taxed at a rate of 20%. (28 percent for residential property).

Is a Discretionary Trust appropriate for me?

A Discretionary Trust may be a good choice for you if you wish to establish a trust for a specific class of beneficiaries, such as your children or grandchildren, while retaining control over the monies you gift.

You do, however, need to be aware of the added intricacies in trustees’ tasks, such as how the trust is considered in terms of taxation and administrative cost.

With so many various types of trust arrangements available, determining whether a trust is the right answer for you, or which trust would be most acceptable given your needs, may be incredibly difficult.

Discretionary Trust FAQs

Who owns the assets in a discretionary trust?

A trustee
While the trustee legally owns discretionary trust assets, the trustee does not beneficially possess the assets. The trustee must manage and secure the assets for the benefit of the entire pool of possible beneficiaries, but no beneficiary has the right to demand an asset or income from the trustee.

What is the difference between a fixed trust and a discretionary trust?

Normal express trusts are referred to as “fixed” trusts since the trustees are obligated to distribute property to a specified number of beneficiaries with no choice. Discretionary trusts, on the other hand, are those in which the trustee has discretion over his actions but is required to act.

Can you change the beneficiaries of a discretionary trust?

As the Trustee of a Discretionary Trust, you have the authority to distribute Trust Property to the Beneficiaries at your discretion. This also includes the ability to change the beneficiaries of a discretionary trust.

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