What is a trust fund and how does it work?

Trust funds are designed to protect your wealth, giving you more control than a will even after you’ve passed away. But they can be tricky to understand, making the benefits difficult to access.

In this guide you’ll learn what a trust fund is, what the different types are, the benefits of trusts, and how they’re taxed.

What is a trust fund?

A trust fund places cash, property, and other valuable possessions into a secure account for the future. They work similarly to a will because they outline how you want your wealth to be distributed. The key difference is that a will only takes effect when you pass away. A trust makes use of your funds whenever you wish.

There are a handful of reasons why someone might open a trust. But one of the most popular is to hold and grow wealth for others to inherit.

Trusts involve three or more people taking on the following roles:

• Settlor: the person paying into the trust (you)
• Trustees: the people managing the trust (friends, family, wealth managers, or solicitors)
• Beneficiaries: the people benefitting from the trust (usually children or other loved ones)

This means you can choose exactly when your loved ones will receive the money. It’s common for people to receive trusts once they reach a certain age, or immediately after your passing.

It’s also possible to enjoy tax relief on trusts - depending on the type - making them an attractive way to gift money to family.

Revocable vs. irrevocable trust funds

Trust funds are either revocable or irrevocable. Which option is better for you depends on how much control or flexibility you want:

• Revocable trusts: You maintain full control to amend or cancel the trust at any time. Wealth in a revocable trust is considered part of your estate for tax purposes (more on this later).
• Irrevocable trusts: Can’t be changed or cancelled without the approval of your trustees. Anything placed in the trust is no longer part of your estate, potentially reducing your taxes in some circumstances.

If you’re considering opening a trust fund, it’s important to weigh up the benefits and disadvantages.

What are the benefits of trust funds?

Reducing the tax you pay

Trust funds may help reduce the Inheritance Tax (IHT) you pay, depending on your personal circumstances. This is because the value of everything you own is calculated for tax purposes when you pass away (known as your ‘estate’). In theory, giving your wealth away in advance should limit your Inheritance Tax charges.

But the rules are complex. There are also risks your costs could increase if they are set up incorrectly. Depending on who pays the tax, when the funds are accessed, and when you pass away, you could pay a different amount than you might expect.

The cash you gift in a trust is taxed at the beneficiary’s rate, not yours. As a result, if you have a larger income than your loved ones, giving cash through a trust can mean you pay less tax overall.

Tax rules are frequently subject to change. Your personal finances can significantly impact how much or how little you can benefit. Seek guidance from a qualified financial adviser to understand how your circumstances impact your tax obligations before making important decisions.

Controlling the distribution of your wealth

A ‘revocable trust’ gives you complete control over the conditions in which someone inherits your estate.

For example, you can specify that you’d like any wealth you pass on to be spent responsibly, and define what that means in line with your values. You can also prevent the money from being included in divorce settlements.

What are the disadvantages of trust funds?

Complex taxes, costs, and charges

It can be expensive to set up and maintain a trust. Here are some of the main costs to consider:

Inheritance Tax: You’re charged 20% on balances over £325,000 immediately, and a further 6% on the value of the trust every 10 years. Depending on when the trust is opened, this can halve your Inheritance Tax bill. But if you pass away within seven years of making a transfer into a trust, you pay the standard rate of Inheritance Tax at 40%.

Income Tax: Income you earn through the trust is charged at 45% if you make over £1,000. Beneficiaries can potentially claim some of this tax back, but the rules are complicated.

Capital Gains Tax: The profit you make from the sale of residential properties is charged 28% Capital Gains Tax if they’re held in a trust.

Exit charges: When you withdraw money from the trust, you pay a 6% charge on the amount.

Set-up and management costs: You’ll need to pay fees to solicitors and wealth managers to take care of the trust.

Permanent gifting

In an irrevocable trust, you hand over your rights to the trustees. This is legally binding. You can’t take your assets back if you change your mind.

Types of trust funds

There are a handful of different types of trust funds in the UK, each with unique rules. The list of trusts includes: Bare Interest in possession Accumulation Discretionary Mixed Settlor-interested Non-resident Here’s how they work:

Bare trusts

Your wealth is held in the name of whoever manages the trust, usually until a child turns 18 (or 16 in Scotland). The trust is then transferred to the whoever you’ve named as the beneficiary.

Interest in possession trusts

When a trust earns income, either through interest on cash, rent on buildings, or business profits, the money is immediately transferred to the beneficiaries. Although they earn money from the income generated by the trust, the beneficiaries don’t own the assets held in it.

Accumulation trusts

The people managing the trust can invest the income it generates, either by making separate purchases or adding to the trust itself. In an accumulation trust, you don’t have to give money to beneficiaries right away.

Discretionary trusts

You give the trustees full power to manage your wealth. They decide how and when it’s passed on. While you can still outline your preferences, trustees don’t have to follow your recommendations.

Mixed trusts

This lets you combine the rules of different trusts. For example, you can specify that one beneficiary enjoys interest in possession rights. Another beneficiary in the same trust has bare trust rights, meaning they’d only earn money once they reach the right age.

Settlor-interested trusts

You, your spouse, or both are listed as beneficiaries. Whatever the trust earns is treated as your income for tax purposes.

Non-resident trusts

Most of the people managing your trust are located outside of the UK. This makes tax rules complicated, which is why seeking the support of a financial adviser can be helpful.

How to set up a trust fund in the UK

Once you’ve checked whether a trust fund is right for you with a financial adviser, you’re ready to start the process.

The wording of the trust fund needs to be precise to avoid legal problems in the future. As a result, hiring a solicitor to write the initial document is usually the first step.

Next, decide on the type of trust that makes sense for your estate. Some types of trust are more complex to set up than others. This can increase your costs, as solicitors can charge by the hour for advice and support.

Choose your trustees and beneficiaries carefully. Ensuring that trustees have a high level of financial literacy is important. If you have other children, consider making a neutral third party a trustee to encourage impartial decision-making.

The final step is to draft the legal document defining the terms of the trust and register it with HMRC.

Frequently asked questions about UK trust funds

How much money do you need to set up a trust?

There is no minimum amount you need to set up a trust fund in the UK.

Who is entitled to a trust fund in the UK?

Anyone can set one up, but to access the wealth in a trust fund, you must be named as one of the beneficiaries. The rules of the trust place additional limits on your access.

Do you pay tax on a trust fund in the UK?

Yes. But the amount of tax you pay, as well as which taxes apply, can vary significantly.

You may have to pay Inheritance Tax, Capital Gains Tax, or Income Tax on the money you earn from a trust. The exact amount depends on a handful of factors including the type of trust, who benefits, and how long ago it was opened.

Pass on wealth as you wish with trust funds

Trust funds can give you extensive control to pass on your wealth as you wish. Depending on how you create your trust funds, you can even limit the tax you pay on what you’ve set aside, so that more of your money stays with your loved ones.

It’s important to seek professional guidance if you’re unsure how to safeguard your wealth.

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