How Do Trusts Help Reduce Inheritance Tax

At Towerstone, we provide specialist Inheritance Tax accountancy services for families and executors. We have written this article to explain how trusts can be used and common pitfalls, helping you make informed decisions.

From experience, trusts are one of the most misunderstood tools in UK inheritance tax planning. Some people think trusts are only for the ultra wealthy, others believe they are a loophole that HMRC is trying to shut down, and many assume trusts automatically avoid inheritance tax. In my opinion, none of those views are quite right.

Trusts can help reduce inheritance tax, but only when they are used properly, for the right reasons, and with a clear understanding of how HMRC treats them. Used well, trusts can protect family wealth, control how assets are passed down, and in certain cases reduce the inheritance tax bill. Used badly, they can create complexity, ongoing tax charges, and disappointment.

In this article, I am going to explain clearly how trusts work in the UK, how they interact with inheritance tax, and when they can be effective as part of a wider estate planning strategy. I will draw on real situations I see in practice and explain not just the theory, but how things actually play out when estates are reviewed.

By the end, you should understand what trusts can and cannot do, which types of trusts are commonly used, how inheritance tax charges arise, and when a trust makes sense in real life rather than just on paper.

A quick reminder of how inheritance tax works

Before looking at trusts, it is important to ground this discussion in how inheritance tax works in the UK.

Inheritance tax is charged on the value of a person’s estate when they die. The estate includes:

Property

Cash and savings

Investments

Personal possessions

Certain lifetime gifts

Inheritance tax is administered by HM Revenue and Customs, with detailed guidance published on GOV.UK.

The core rules are:

Each individual has a nil rate band of £325,000

Anything above this may be taxed at 40 percent

Additional allowances may apply in certain situations

From experience, the key thing to remember is that inheritance tax is about value leaving your estate, not about how complicated your arrangements look.

What is a trust in simple terms?

, a trust is a legal arrangement where assets are held by one party for the benefit of others.

There are three main roles in a trust:

The settlor, the person who puts assets into the trust

The trustees, the people who control and manage the trust

The beneficiaries, the people who benefit from the trust

When assets are placed into a trust, they are no longer owned outright by the settlor. Instead, they are owned by the trustees in accordance with the trust deed.

In my opinion, this separation of control and benefit is the foundation of how trusts can help with inheritance tax planning.

Why trusts are used in inheritance tax planning

From experience, people use trusts for several overlapping reasons, not just tax.

Common motivations include:

Reducing inheritance tax exposure

Controlling how and when children receive assets

Protecting vulnerable beneficiaries

Protecting family wealth from divorce or bankruptcy

Managing complex family situations

Inheritance tax is often the trigger for the conversation, but trusts are rarely just about tax alone.

Do trusts automatically avoid inheritance tax?

No, and this is one of the biggest misconceptions I encounter.

In my opinion, anyone who tells you that trusts automatically avoid inheritance tax is oversimplifying or misleading you.

Trusts change when and how inheritance tax may apply, but they do not make assets invisible to HMRC.

The tax outcome depends on:

The type of trust

When assets are placed into the trust

The value of the assets

Whether the settlor survives for a certain period

How the trust is structured and operated

Lifetime trusts and inheritance tax

One of the most common ways trusts are used to reduce inheritance tax is through lifetime gifting into trust.

When you place assets into a trust during your lifetime, you are effectively giving them away. The inheritance tax treatment depends on the type of trust used.

From experience, this is where professional advice is essential.

Bare trusts and inheritance tax

A bare trust is the simplest form of trust.

In a bare trust:

The beneficiary has an absolute right to the assets

The trustees have no discretion

The assets are treated as belonging to the beneficiary for tax purposes

From an inheritance tax perspective, assets placed into a bare trust are treated as a potentially exempt transfer.

This means:

No inheritance tax is due at the time of the gift

If the settlor survives seven years, the assets fall outside their estate

If the settlor dies within seven years, the value may be taxed

In my opinion, bare trusts are simple but limited. They offer little control and are often used for children or straightforward gifting.

Discretionary trusts and inheritance tax

Discretionary trusts are the most commonly discussed trusts in inheritance tax planning.

In a discretionary trust:

Trustees decide who benefits, when, and how much

Beneficiaries have no automatic right to trust assets

The trust offers flexibility and control

From an inheritance tax perspective, discretionary trusts work very differently.

When assets are placed into a discretionary trust:

The transfer is usually a chargeable lifetime transfer

If the value exceeds the nil rate band, an immediate inheritance tax charge of up to 20 percent may apply

From experience, this often surprises people. The tax is not avoided, it is brought forward.

Why would anyone accept an immediate tax charge?

In my opinion, this is where long term planning comes in.

Paying inheritance tax at 20 percent during life can sometimes be preferable to paying 40 percent on death, particularly if:

The estate is already well above the thresholds

The settlor expects to live for many years

Future growth is removed from the estate

From experience, discretionary trusts are often used to freeze the value of an estate.

The seven year rule and trusts

The seven year rule still plays a role with trusts, but it works differently depending on the trust type.

For potentially exempt transfers, such as bare trusts:

Survive seven years and the gift is fully exempt

For chargeable lifetime transfers, such as discretionary trusts:

Surviving seven years may reduce additional tax on death

The initial 20 percent charge still stands

In my opinion, understanding this distinction is crucial.

The nil rate band and trusts

The nil rate band can be used during lifetime to shelter assets placed into trust.

For example:

Up to £325,000 can be placed into a discretionary trust without an immediate inheritance tax charge

This uses up the settlor’s nil rate band

From experience, this is often done in stages rather than in one large transfer.

Ongoing inheritance tax charges on trusts

One of the most important things people overlook is that trusts can be subject to ongoing inheritance tax charges.

Discretionary trusts are subject to:

Ten year anniversary charges

Exit charges when assets leave the trust

These charges are usually up to 6 percent of the trust value above the nil rate band.

In my opinion, this is where unrealistic expectations often arise. Trusts are not tax free vehicles.

How trusts remove future growth from your estate

One of the biggest inheritance tax advantages of trusts is removing future growth from your estate.

Once assets are placed into a trust:

Their future growth usually sits outside the settlor’s estate

Inheritance tax is calculated on the value at the time of transfer

From experience, this can be very powerful where assets are expected to grow significantly.

Trusts and the gift with reservation of benefit rules

Trusts do not bypass the gift with reservation of benefit rules.

If you place an asset into trust but continue to benefit from it, HMRC may treat it as still part of your estate.

Examples include:

Living in a property owned by a trust without paying market rent

Retaining unrestricted access to trust assets

In my opinion, this is a common trap and one that HMRC actively challenges.

Trusts created on death and inheritance tax

Not all trusts are created during life.

Many trusts are created by a will and only come into effect on death.

These include:

Life interest trusts

Discretionary trusts within wills

From an inheritance tax perspective, these trusts do not usually reduce the tax due on death itself, but they can help with:

Protecting assets for future generations

Using allowances effectively between spouses

Managing how assets are passed on

From experience, will trusts are often more about control than immediate tax savings.

Life interest trusts and inheritance tax

A life interest trust gives one person the right to benefit during their lifetime, with the assets passing to others later.

Common examples include:

A surviving spouse having the right to live in the family home

Children inheriting after the spouse’s death

For inheritance tax:

Assets are usually treated as belonging to the life tenant

Spouse exemption often applies

In my opinion, life interest trusts are more about family protection than inheritance tax reduction.

Trusts for children and grandchildren

Trusts are often used to pass wealth down generations while maintaining control.

From experience, common reasons include:

Children being too young to manage money

Protecting assets from divorce

Avoiding sudden large inheritances

Inheritance tax planning here is usually about timing and structure rather than elimination.

Trusts and the residence nil rate band

This is a crucial point that is often missed.

Leaving a home into certain types of trust can jeopardise the residence nil rate band.

From experience, discretionary trusts containing the family home often do not qualify unless structured very carefully.

In my opinion, this is one of the biggest reasons wills need regular review.

Are trusts still worth it?

In my professional opinion, trusts are still valuable, but they are not a default solution.

Trusts work best when:

Estates are large

Family situations are complex

Control and protection matter as much as tax

Advice is taken early

For smaller estates, trusts can add cost and complexity without meaningful tax savings.

Common myths about trusts and inheritance tax

Some of the most common misunderstandings I hear include:

Trusts avoid inheritance tax completely

HMRC cannot see trust assets

Trusts are only for the wealthy

Trusts are no longer effective

From experience, the truth sits somewhere in the middle.

Practical advice from experience

If you are considering trusts as part of inheritance tax planning, my practical advice is:

Be clear about your objectives

Understand the ongoing costs and taxes

Do not rush into trust structures

Review your plan regularly

Take advice that considers your whole estate

Trusts should support your family goals, not complicate them unnecessarily.

Where this leaves you

So, how do trusts help reduce inheritance tax?

They do not magically remove tax, but they can:

Shift tax from death to lifetime

Reduce the overall tax rate in some cases

Remove future growth from your estate

Provide control and protection alongside tax planning

From experience, the biggest mistake is seeing trusts as a silver bullet. They are a tool, not a shortcut.

In my opinion, when trusts are used thoughtfully, with realistic expectations and proper advice, they can play a valuable role in inheritance tax planning. When they are used blindly or sold as a simple fix, they often disappoint.

If there is one thing I would emphasise, it is this. Trusts work best when they are part of a broader, well understood estate plan, not when they are used in isolation or as a reaction to fear about inheritance tax.

If you would like to explore related Inheritance Tax guidance, you may find How does the main residence nil rate band work and How is Inheritance Tax calculated in the UK useful. For broader inheritance tax guidance, visit our inheritance tax hub.