Understanding Trusts

How Do Trusts Work? Simply Explained

Have You Heard the Term Trust but Unsure of What It Means? Here Are the Ins & Outs of Trusts & How They Can Benefit Your Family's Future.

Understanding Trusts

Understanding Trusts

Do you want to set up a Trust1 as part of your estate planning strategy? Most people assume that trusts were just created to cater to the super-rich, but you might be surprised to learn these smart financial strategies have been around since Roman times. In the Roman Republic, it was illegal to transfer property at death to unmarried persons, slaves, childless couples, and foreigners.

Therefore, to circumvent these stringent inheritance laws, the fideicommissa” (Trust) was established. These agreements were oral and held in secrecy since their mere existence could lead to the confiscation of assets. Nonetheless, they served their purpose, and today; they’re one of the smartest ways to avoid inheritance tax implications.

So, one might ask, how do trusts work, what types of trusts are there, and how much does it cost to set up these trusts? Here’s a comprehensive guide, exclusively tailored to get a sense of the world of Trusts.

Trusts Explained

In case you’re wondering

A Trust is typically a set of instructions that one draws up to make someone or a group of persons responsible for taking care of your estate or capital, for the benefit of another group of people. It’s a tad bit confusing, right?

Well, the person who draws up the Trust is known as the settlor.

The people who administer the Trust are referred to as the trustees. They have the same authority a person would have to purchase, sell and invest their estate. It’s also the trustees’ responsibility to run the trust fund and manage its assets responsibly.

On the other hand

The group of people who benefit from the Trust is referred to as the beneficiaries. They’re usually unable to manage the Trust’s assets for themselves since they’re too young or they’re not considered good at managing their capital. Therefore, the assets are held in the trust fund for the beneficiary’s benefit.

Why Should You Set Up A Trust

Why Should You Set Up A Trust?

There are several reasons why you should consider setting up a trust fund. First, it’s one of the best ways of cutting down the tax your loved ones would have to pay on inheritance. However, like any other financial affair, you need professional advice to make sure everything runs smoothly. You can talk to a solicitor or independent financial advisor since they’re best suited to guide you.

Now

If you place assets into the Trust then, as long as specific conditions are met, these assets are no longer yours. It means that when you pass away, their value won’t be counted when the inheritance tax bill is worked out.

Instead, the capital, investments, and property belong to the Trust. In other words, when you transfer assets into the trust fund, they’re considered to be outside of your estate for inheritance tax purposes.

Another potential benefit is that Trusts are a way of maintaining control and asset protection for the beneficiary – it avoids handing over valuable assets, capital, or investments whilst the beneficiaries are relatively young or considered vulnerable.

And the good news?

A Trust also safeguards the beneficiary against hostile creditors like:

  • Divorce – any capital left in the Trust cant be taken into account as part of a divorce settlement.
  • Bankruptcy – finances left in the trust fund aren’t liable to be yielded as part of asset insolvency in the bankruptcy2 proceedings.

Lastly, when you set up the Trust, you decide on the rules of engagement and how the trustees will manage it. For instance, you can say that your kids will only get access to the trust fund when then they reach 18,20, or even 25 years of age.

Types of Trusts

Types of Trusts

Let’s dig deeper

Some of the most popular types of Trusts include:

Bare Trusts

They’re also referred to as Simple Trusts. In these, the beneficiary gets immediate and the absolute right to manage and access the assets and any income generated from them. The settlor can be confident that the assets will go directly to the heirs they select. However, once you set up the Bare Trust, those beneficiaries can’t be changed.

Discretionary Trusts

Discretionary Trusts are where the trustees have absolute authority to decide how the assets in the Trust are distributed. You can set up this form of Trust for your grandkids and leave it to the trustees (who could be your kids), to figure out how to divide the income and capital between your grandchildren.

The trustees also have the power to make any investment decisions on behalf of the trust fund. These type of Trusts is best suited for:

  • Those who want to make sure that a disabled relative is adequately provided for
  • Those who want to mitigate a potential inheritance tax
  • People with beneficiaries who are minors

Interest in Possession Trusts

Interest-in-Possession Trusts are where the beneficiary can get income from the Trust straight away but doesn’t have access to the cash, estate, or investments that generate that income. The beneficiary will have to pay income tax on the revenue generated.

You can set up this form of Trust for your spouse, with the understanding that when they pass away, the investments of the Trust will pass on to your kids.

Here’s an interesting fact:

It’s a highly sought-after Trust structure, and it’s mostly used in the Will of a person who remarries after divorce but has kids from the first marriage.  The Trust entitles the beneficiary to Trust income as it’s generated.

The Trust is perfect for:

  • Mature couples who want to equalise their property
  • Families where one or both partners have kids from a previous union
  • Couples where there’s a considerable age gap between the partners
  • Couples who individually want to make sure that the inheritance of their kids or other beneficiaries, without forcing their spouses to sell their residence

Mixed Trusts

Mixed Trusts combine factors from various forms of Trusts. For instance, a beneficiary might have an Interest in Possession, the right to the income, of half of the trust fund. The remaining half of the Trust can then be held on Discretionary Trust.

Non-Resident Trusts

Non-Resident Trusts are run by trustees who aren’t UK residents for taxation reasons. They’re complicated, and in some cases, only a couple or one of the trustees will be UK residents.

The settlor might not be a UK resident when the Trust was drawn up or when the property was added to it.

Parental Trusts for Minors

These are typically Trusts for the settlor’s minor unmarried kids, looking after income as though it was the settlor’s for tax purposes.

Settlor-Interested Trusts

Settlor-Interested Trusts, as the name suggests, is where the settlor, their spouses, or civil partners might also benefit from the Trust. They’re set when, for instance, a partner knows that he or she is possibly going to be incapacitated by illness and needs to direct assets for his or her future.

Vulnerable Beneficiaries Trusts

Vulnerable Beneficiaries Trusts are drawn up for those who are physically or mentally challenged, or they’re under the age of 18, and their parents have died. They’re eligible for special treatment when it comes to capital gains taxed and income, provided that it’s a qualifying trust, where the person who establishes it doesn’t get any benefits from it.

Business Trusts

Let me tell you something

One can use a Business Trust to ensure that when a partner or shareholder passes away, the capital paid out on their death, usually through a Life Assurance Policy, is paid out to the remaining stakeholders or partners in an organization. The partners can use the capital to purchase back the shares of the firm from the deceased’s estate so that the control of the firm remains at the hands of the other shareholders or partners.

However, to be able to buy the deceased’s shares, the shareholders or partners have to sign a cross-option agreement.

Relevant Life Trust

The Relevant Life Trust is typically a life insurance policy an employer can use to offer death-in-service perks for an employee. When the employee passes away, the benefits can be paid to his or her family.

To reduce any IHT liability, you should remember to write the policy under the Discretionary Trust.

How Much Does it Cost to Set Up A Trust

How Much Does it Cost to Set Up A Trust?

Instructing a solicitor to help you draw up a Trust can be costly. Trusts cost about £1,000 to £5,000. However, despite the expenses, using a solicitor will help you avoid expensive mistakes further down the line. For instance, you can make a costly mistake if the wording of your Trust is ambiguous or misleading. Thus, a solicitor will check it and help you set up one that will be mistake-free, saving loads of cash in court proceedings.

You see

There are also some charity foundations that have schemes where they contribute towards the parent’s expenses of setting up a Trust for a disabled kid. So, you can check out and see if one of them can assist you.

Inheritance tax can be a headache, and since you don’t want to leave your children in financial liability, setting up a Trust will be the best way of ensuring they enjoy their inheritance without the taxmen’s interference.

Read more about pensions plans next!

Common Questions

Can Trusts Help in Reducing Inheritance Tax?

How Are Trusts Taxed in the UK?

How Do Trusts Work in the UK?

What's Better A Will Or A Trust?

In Conclusion

In short,

One of the most important and confusing parts of estate planning is understanding trusts. Trusts are a way to give assets you own (such as money, real estate, personal property) to someone else while retaining some control over how those assets are used. They’re also one of the most powerful tools for protecting your loved ones’ financial security.

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Editorial Note: This content has been independently collected by the EveryInvestor advisor team and is offered on a non-advised basis. EveryInvestor may earn a commission on sales made from partner links on this page, but that doesn’t affect our editors’ opinions or evaluations. Learn more about our editorial guidelines.
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