Discounted Gift Trusts and IHT: How the Settlor Retains Income While Reducing Their Estate
A discounted gift trust lets you make a substantial gift into trust while retaining fixed regular withdrawals for life. The gift is discounted for IHT immediately — because the retained withdrawals have a present value — reducing the chargeable transfer from day one. After 7 years, the remaining gift element falls outside your estate entirely.
How a Discounted Gift Trust Works
1. Settlor makes a lump sum gift into trust
The settlor (typically age 55+) transfers a lump sum — usually invested in an investment bond or similar wrapper — into a discretionary or bare trust. The trust is established for the benefit of the settlor's chosen beneficiaries (e.g. children or grandchildren). The settlor cannot benefit from the trust capital — with one critical exception: the retained right to fixed regular withdrawals.
2. Settlor retains the right to fixed regular withdrawals
The settlor retains the legal right to receive fixed regular withdrawals from the trust — typically expressed as a percentage of the original investment per annum (e.g. 5% per year). These withdrawals are paid for the remainder of the settlor's life. The settlor cannot vary the amount — the withdrawals must be fixed at outset. This retained right is what creates the 'discount': the present value of the future withdrawals is calculated actuarially and deducted from the gift value.
3. The discount reduces the chargeable transfer immediately
The chargeable transfer for IHT purposes is not the full lump sum invested — it is the lump sum minus the actuarial value of the retained withdrawals (the 'discount'). For example: £500,000 invested, 5% withdrawals, settlor aged 70 in good health. The discount might be £200,000 — meaning the chargeable transfer on entry is only £300,000. If this is within the NRB (£325,000), no immediate IHT is due. The IHT saving is front-loaded: the discount reduces the estate immediately, not just after 7 years.
4. The 7-year clock runs from the date of entry
The remaining gift element (the discounted amount) starts its 7-year potentially exempt transfer (PET) clock or, if the trust is discretionary, the CLT clock from the date the money is paid into the trust. If the settlor survives 7 years from the date of the gift, the entire discounted amount falls outside the estate. The withdrawals continue to be paid — but they are already included in the settlor's estate as they are received (they are income/receipts into the estate). The key is that the growth within the trust fund is outside the estate from day one.
5. On the settlor's death
When the settlor dies, the right to withdrawals ceases — it was a personal right, not a transferable asset. The trust fund (capital plus growth, less withdrawals paid) passes to the beneficiaries under the trust terms. If the settlor dies within 7 years of the gift: the discounted gift element is brought back into the estate (as a failed PET or CLT depending on trust type) for IHT recalculation — but only the discounted amount, not the full investment. The growth in the trust is always outside the estate. If the settlor dies after 7 years: the entire gift element is outside the estate.
Frequently Asked Questions
How is the discount in a discounted gift trust calculated?
The discount is calculated by an actuary (or insurer's underwriting team) based on the present value of the fixed withdrawals the settlor is retaining. The key variables are: (1) the settlor's age — older settlors have a lower life expectancy, so the present value of future withdrawals is lower, meaning a smaller discount; (2) the settlor's health — poor health reduces the discount (shorter expected payment period); (3) the withdrawal rate — higher withdrawals per year mean a larger discount; (4) assumed investment return — the discount is the discounted present value of the income stream. HMRC has published guidance on acceptable discount rates and actuarial methodologies. Providers typically obtain a medical questionnaire and may require medical evidence for larger investments. The discount is agreed between the provider and HMRC at the time of the investment.
Is a discounted gift trust a CLT or a PET?
It depends on the type of trust used. If the DGT uses a bare trust (often called a 'gift trust' or 'absolute trust'), the discounted gift element is a PET — no immediate IHT on entry, but it falls back into the estate if the settlor dies within 7 years. If the DGT uses a discretionary trust, the discounted gift element is a CLT — potentially subject to a 20% IHT charge on entry if the discounted amount exceeds the available NRB, plus 10-year periodic charges and exit charges on the trust fund. Most DGTs use a bare trust for smaller sums (within the NRB) and a discretionary trust for larger amounts where the settlor wants maximum flexibility for the trustees in distributing to beneficiaries. The choice of trust type has significant IHT consequences and should be considered carefully.
What happens to the withdrawals if the settlor stops taking them?
The right to withdrawals in a DGT is fixed and cannot be varied — the settlor either takes the withdrawal or waives it. Importantly, the settlor cannot waive the right to withdrawals after the trust has been established without potentially creating a further transfer of value for IHT purposes. If the settlor simply stops taking withdrawals (i.e. does not request payment), the uncollected withdrawals typically accumulate in the trust — adding to the trust fund. This can create complications: the accumulated right to uncollected withdrawals may remain an asset of the settlor's estate, depending on how the trust deed is drafted. DGT providers and their trustees should be consulted before the settlor changes their withdrawal pattern.
What are the income tax implications of a discounted gift trust?
The withdrawals from a DGT are typically funded from an investment bond held within the trust. Withdrawals up to 5% of the original investment per year (cumulative) can be taken from an investment bond without immediate income tax — they are treated as a return of capital under the 5% annual tax deferred allowance. This means the settlor can receive regular withdrawals without triggering an income tax charge in the year of withdrawal. If withdrawals exceed the 5% limit (cumulative), a chargeable event gain may arise and be taxed on the settlor as income. The tax efficiency of the withdrawal mechanism is one of the reasons DGTs are typically structured around investment bonds. The trust itself — if discretionary — is subject to the income tax rates applicable to discretionary trusts (45% on income, 38.75% on dividends) on any income not distributed to beneficiaries.
Is a discounted gift trust suitable for everyone?
No. Key suitability considerations: (1) Age and health — the discount is most valuable for younger, healthier settlors. Older or seriously ill settlors may receive very little discount, making the DGT less IHT-effective. (2) Need for income — the settlor must genuinely need the fixed withdrawals. If the settlor has other sources of income and simply wants the discount, HMRC may challenge whether the retained right is genuine. (3) Liquidity — the lump sum is locked into the trust. The settlor cannot access the capital (only the fixed withdrawals). If the settlor may need capital flexibility in the future, a DGT is not appropriate. (4) 7-year survival — like all PETs and CLTs, the full IHT benefit requires the settlor to survive 7 years. Taper relief applies in years 3–7 but the maximum benefit requires full 7-year survival. (5) Trust costs — DGTs involve ongoing trust administration, trustee costs, and potential periodic IHT charges (for discretionary trusts).
How does a discounted gift trust compare to a loan trust for IHT planning?
Both DGTs and loan trusts allow the settlor to benefit from the trust fund while reducing their estate. The key differences: (1) In a DGT, the settlor makes a gift — the trust fund (less withdrawals) is outside the estate immediately, and grows outside the estate. In a loan trust, the settlor makes an interest-free loan to the trustees — only the outstanding loan balance is in the estate (not the growth). (2) In a DGT, the settlor retains fixed withdrawals (which reduce the capital in the trust). In a loan trust, the settlor can call back the loan at any time (repayment reduces the loan balance in the estate). (3) The DGT has the advantage of an immediate discount on the gift element — reducing the estate from day one by the actuarial value of the withdrawals. The loan trust has no immediate discount but preserves full flexibility for the settlor to recall the loan. (4) DGTs are more IHT-efficient in the long run (especially with 7-year survival) but are less flexible. Loan trusts are more flexible but the loan remains in the estate until repaid.
Planning to Reduce Your Estate While Keeping an Income?
A discounted gift trust is one piece of a comprehensive IHT plan. The other essential piece: a will that ensures the right assets reach the right people. WillSafe will kits give you the foundation.
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