A few months ago I looked at the opportunities whole of life policies can offer when it comes to inheritance tax (IHT) planning. This time we delve deeper into Discounted Gift Trusts (DGTs) and their role in strategically mitigating IHT liabilities.
But first... what is a DGT?
A DGT presents individuals, referred to as ‘settlors’, with the opportunity to gift a lump sum into a trust while retaining the right to fixed regular payments, concurrently reducing potential IHT on their estate.
When establishing a DGT, the settlor specifies regular capital payments for their lifetime or until the fund is depleted. These payments are facilitated through partial withdrawals from an investment bond using the 5% withdrawal facility. The DGT provider calculates the amount needed from the bond to cover these withdrawals, incorporating an estimation of the settlor's life expectancy based on medical underwriting, health questionnaires, and a GP report.
The capital required for withdrawals is termed the ‘discount’, effectively reducing the value of the gift to the DGT for IHT purposes immediately. This reduced gift value remains within the settlor's estate for seven years unless exempted.
Let’s take a look at a case study
Mr and Mrs Sims are aged 70, with an ongoing IHT liability of £600k. A strategic approach could involve investing £120,000 in a DGT. With a 5% withdrawal each year (£6,000) selected, this can conveniently fund the annual premium on their whole of life policy we set up for them 10 years ago in the previous case study.
It is crucial to underline that the initial 'discount' of 56% on the trust-associated gift immediately reduces Inheritance Tax (IHT), resulting in an instantaneous tax saving of £26,880! Seven years later, the full £120,000 DGT investment exits their estate for IHT purposes, leading to an additional tax saving of £21,120. Consequently, after this 7-year period, the full 40% tax saving of £48,000 is realised in its entirety.
It’s important to note that if a client lacks a use for the DGT ‘income’ there's a risk of inadvertently adding to their estate and exacerbating the IHT issue (DGT income isn’t classed as income for the purposes of the normal expenditure out of income exemption). To address this, careful consideration should be given to either ensuring the client can utilise the DGT income or gifting the ‘income’ of £6,000 using their Annual Capital Exemption (ACE) that’s available to everybody and is limited to £3,000 per year, per donor. In this case, we’re using the £6,000 to fund the whole of life policy premiums and these premiums are covered by the ACE.
The outcome
In summary, we've set up a whole of life policy for Mr and Mrs Sims with a maturity value of £488,, complemented by a DGT for £120,000. From an IHT perspective, the only immediate non-exempt gift is the discounted gift value for the DGT, totalling £52,400. Notably, the remaining £120,000 invested in the DGT is instantly disregarded for IHT purposes, and the £6,000 premium for the whole of life policy is exempt given we are using the ACE.
The cumulative result is that £488,000 will be disbursed from the whole of life policy on the second death. The DGT investment has effectively reduced the IHT liability by £48,000 assuming they survive seven years. Consequently, of the initial £600,000 tax bill, it has been mitigated to £522,, with the whole of life policy payout of £488,000 significantly reducing the estate tax bill to just £64,000.
The alternative
In contrast, an alternative for Mr and Mrs Sims would have been to directly gift £1.5 million to their children in an attempt to offset their £600,000 IHT bill (calculated at 40%, which equals £600,000). However, such a direct gift strategy comes with its own set of implications, including the immediate transfer of a substantial amount of wealth from their estate, and often clients are sometimes nervous around such planning (gifting large amounts).
Opting for a whole of life policy and a DGT has allowed Mr and Mrs Sims to navigate IHT planning more strategically. By utilising these tools, they've managed to address their tax liabilities gradually, potentially preserving more control over their wealth, while still achieving significant tax savings. This approach contrasts with the immediate and substantial wealth transfer involved in a large direct gift.
I mentioned there’s still a £64,000 tax bill which we’ll address in my next article; we should also note that IHT is not static and over decades tax legislation may change - the bill will vary on asset prices and how much of their assets they spend.
I understand there are a wide range of strategies to mitigate IHT but here I’ve tried to demonstrate the power of long-term planning for clients who are nervous around IHT planning, or who buy into the power of starting early!
Next time I’ll look at Business Property Relief and how this will address the last piece of the puzzle (the remaining £64,000 IHT bill).
