How do Discretionary Trusts work?
If you’re asking "How do Discretionary Trusts work?", this article explains their structure, distinctive features, and tax and reporting obligations. Understanding these elements helps Trustees and beneficiaries navigate their roles effectively.
Definition
A Discretionary Trust gives Trustees authority over how, when, and to whom Trust income or capital is distributed. Unlike fixed Trusts, where beneficiaries have set shares, beneficiaries in a Discretionary Trust have no automatic entitlement. Instead, they are part of a defined class (for example, "my children", or "family") and receive benefits only if Trustees choose to grant them.
The terms of the Trust deed, often created via a Will or during the deceased's lifetime, establish who the beneficiaries are and how Trustees should operate, sometimes guided by a non-binding Letter of Wishes.
Key features
- Trustee discretion: Trustees decide which beneficiaries benefit and when. This offers maximum flexibility to respond to changing needs or circumstances.
- Asset protection: Assets held in a Discretionary Trust are shielded from claims against individual beneficiaries. They do not belong to any beneficiary until distributed.
- Longevity: Discretionary Trusts can remain in place for up to 125 years under UK law, enabling long-term use for family planning.
- Indirect benefits: Beneficiaries may receive financial support such as education fees or maintenance, without gaining outright control until permitted.
Tax and reporting rules
Discretionary Trusts fall under the "relevant property" regime for Inheritance Tax (IHT). This brings several tax obligations:
- Entry charges: Assets placed into a Discretionary Trust are treated as chargeable transfers. If the transfer exceeds the settlor's available Nil Rate Band (NRB) (currently £325,000), an immediate IHT charge of 20% may apply.
- Ten‑year charges: Every decade, the Trust may incur an IHT charge of 6% on value exceeding the NRB at the last anniversary date. This must be reported via an IHT account.
- Exit charges: When assets leave the trust, for example, when Trustees appoint funds to beneficiaries, an exit charge of up to 6% may apply on part of the asset value if distributions occur between ten‑year anniversaries.
Why Trusts work and when they are used
Discretionary Trusts are typically used in Wills to protect vulnerable beneficiaries, defer inheritance access, or allow Trustees to manage funds until children reach adulthood. They can also protect assets from creditors, divorce proceedings, or means-tested benefits assessments. These Trusts offer estate planning flexibility, but they also carry administrative complexity and tax costs. Trustees and settlors should plan carefully and put clear structures in place.
Final thoughts
To conclude, how do Discretionary Trusts work? They provide Trustees with wide discretion in managing and distributing assets to beneficiaries, under a structured Trust deed. Trustees must comply with trust instructions and meet stricter tax and reporting rules compared to simpler Trust types. When used effectively, Discretionary Trusts deliver powerful tools for estate planning, asset protection, and beneficiary care.
