Discretionary trusts explained, how they work, who controls them, and when to use one

A discretionary trust is a legal arrangement in which assets are held by trustees on behalf of a group of potential beneficiaries, with the trustees having full discretion over when and how to distribute those assets. No beneficiary has an automatic right to receive anything, the trustees decide.

This flexibility is what makes discretionary trusts so useful for estate planning. It also makes them complex enough that professional advice is always required.

How a discretionary trust works

The settlor transfers assets into the trust. Once transferred, those assets are no longer legally owned by the settlor, they belong to the trustees on behalf of the beneficiaries. For inheritance tax purposes, the assets leave the settlor's estate (subject to the seven-year rule and any entry charge).

The trustees are the legal owners of the trust assets. They manage the investments, make tax returns, and decide how to distribute income and capital to beneficiaries. Trustees can be family members, professional trustees, or a combination. The settlor can also be a trustee, subject to certain restrictions.

The beneficiaries are the potential recipients of trust assets. In a discretionary trust, the class of beneficiaries is defined (for example, "the settlor's children and grandchildren and their spouses") but no individual beneficiary has a fixed entitlement until the trustees exercise their discretion.

The letter of wishes is a non-binding document written by the settlor expressing preferences for how the trust should be managed and distributed. Trustees are not legally bound by it, but it guides their decision-making.

The tax treatment of discretionary trusts

On entry (the chargeable lifetime transfer) When assets are placed into a discretionary trust, this is a Chargeable Lifetime Transfer (CLT). If the value transferred exceeds the available nil-rate band (£325,000), an immediate IHT charge of 20% applies to the excess. If the settlor dies within seven years of the transfer, additional IHT may become due. [1]

For this reason, many discretionary trusts are established with assets below the nil-rate band, avoiding any entry charge.

The ten-year periodic charge Every ten years, the trust is subject to a periodic charge of up to 6% on the value of trust assets above the nil-rate band. The calculation uses the nil-rate band applicable at the time, reduced by any CLTs made in the seven years before the trust was established. [2]

Example: A trust with assets of £600,000 and a nil-rate band of £325,000 would be subject to a periodic charge on £275,000 at up to 6%, a potential charge of up to £16,500 every ten years.

This is still considerably less than the 40% IHT that would apply if those assets remained in the estate.

Income tax and capital gains tax The trust pays income tax at 45% on income above a small standard rate band (20% or 8.75% on the first £500 of income). Beneficiaries who receive distributions are entitled to a tax credit for the tax paid at the trust level and pay additional income tax if their personal rate is higher, or receive a refund if lower. [3]

Capital gains within the trust are taxed at 24% (non-residential property) or 28% (residential property), with a reduced annual exempt amount. [4]

Exit charges When assets are distributed from the trust, an exit charge may apply based on the settlement rate established at the most recent ten-year anniversary. If there was no periodic charge at the last ten-year anniversary (because the value was below the nil-rate band), there will be no exit charge. [2]

When discretionary trusts offer real planning value

1. Inheritance tax planning Assets placed in trust are outside the estate after seven years (or immediately if structured below the nil-rate band). Over a long horizon, a trust can remove significant value from a taxable estate.

2. Life insurance in trust Placing a life insurance policy in a discretionary trust on inception means the death benefit is paid to the trust, outside the estate, rather than forming part of the estate and increasing the IHT bill. This is one of the most cost-effective trust uses and should be considered by anyone with a meaningful life insurance policy.

3. Asset protection Trust assets are not personally owned by beneficiaries. This protects them from claims arising from a beneficiary's divorce, bankruptcy, or poor financial decisions. Where there is concern about a beneficiary's ability to manage wealth, a trust enables controlled access.

4. Multi-generational planning A trust can hold assets across generations, allowing grandparents to benefit grandchildren (including those not yet born) without specifying exactly how assets will be divided. The trustees adapt distribution decisions to circumstances as they develop.

5. Controlled distribution to younger beneficiaries Rather than assets passing outright to a child at 18 (under intestacy or a bare trust), a discretionary trust allows trustees to distribute at a more appropriate age and in a structured way.

Discretionary trust vs bare trust

A bare trust differs fundamentally: the beneficiary has an absolute and immediate entitlement to the assets. Bare trusts are simpler and have different tax treatment but offer no flexibility or protection, once established for a named beneficiary, that person has the right to demand the assets at age 18.

For estate planning purposes, discretionary trusts offer far greater flexibility.

Frequently asked questions

Can I be both the settlor and a trustee of a discretionary trust? Yes, but with important restrictions. As a trustee-settlor, you must not benefit from the trust (otherwise the gift-with-reservation rules bring the assets back into your estate). Many settlors are trustees who manage the trust but exclude themselves as potential beneficiaries.

What happens to a trust when the settlor dies? The trust continues. The trustees continue to manage assets and make distributions according to the trust deed and any letter of wishes. The settlor's death may trigger an IHT calculation if it occurs within seven years of the CLT.

How long can a trust last? UK trusts can last up to 125 years. A trust established by grandparents can, in principle, continue to benefit great-grandchildren and beyond.

Are trust assets protected from the beneficiaries' creditors? Generally yes. Assets in a discretionary trust are not personally owned by beneficiaries. A creditor of a beneficiary cannot compel the trustees to make a distribution, though they may take any distribution once it has been made.

This article provides general information only and does not constitute personal financial or tax advice. Tardi Group recommends professional advice before establishing a trust.