Discretionary Trusts and Inheritance Tax Explained: A 2026/27 Guide

A trust is a legal relationship in which one party (the trustees) holds and manages property for the benefit of another party (the beneficiaries). The person who creates the trust and transfers assets into it is the settlor. In a discretionary trust, no beneficiary has a fixed entitlement to anything — instead, the trustees have power to decide which beneficiaries receive income or capital, in what proportions, and when.

The class of beneficiaries is set out in the trust deed. It is usually drawn widely — for example, "my children, grandchildren and any further issue" — to give trustees room to respond to changing family circumstances. The settlor can also leave a non-binding "letter of wishes" alongside the trust deed, suggesting how they would like trustees to exercise their discretion.

Discretionary trusts can be set up during the settlor's lifetime, when they are sometimes called lifetime trusts, or they can be created on death through a will, in which case they are will trusts. The tax rules are similar in both cases, but the timing of charges differs.

Most discretionary trusts fall within what is called the "relevant property regime" for inheritance tax. There are three potential charges to think about.

The first is the entry charge. When the settlor transfers assets into a lifetime discretionary trust, the transfer is a chargeable lifetime transfer, or CLT. The settlor's available nil-rate band — currently £325,000 for 2026/27, frozen until 5 April 2030 — is applied first. If the transfer (together with any other CLTs in the previous seven years) exceeds the available nil-rate band, the excess is charged at 20% immediately, payable by the trustees, or at an effective 25% if the settlor pays the tax.

If the settlor dies within seven years of making a CLT, the transfer is reassessed at the death rate of 40%, with credit given for the 20% lifetime charge already paid. Taper relief may reduce the additional charge if death occurs between three and seven years after the transfer.

For will trusts, no entry charge applies — the assets pass into trust as part of the deceased's estate, with normal estate-level inheritance tax rules taking effect.

Once a discretionary trust is in place, it is also subject to a periodic, or "principal", charge on every 10-year anniversary of its creation. The charge can be up to 6% of the value of the trust assets that exceed the trust's available nil-rate band at the anniversary date. The £325,000 nil-rate band available to the trust may be reduced by any chargeable lifetime transfers the settlor made in the seven years before the trust was created.

The maximum 6% rate is derived from 30% of the lifetime IHT rate of 20%, but in practice the effective rate is often considerably lower because of the way the value of the trust assets is averaged against the nil-rate band. Trustees normally seek professional advice in the run-up to a 10-year anniversary to value the trust accurately and to consider whether any planning steps are appropriate.

For trusts created out of a will, the 10-year clock runs from the date of death, not from when the will was written.

Whenever capital is paid out of the trust to a beneficiary between 10-year anniversaries, a proportional exit charge can apply. The rate is based on the effective rate at the previous 10-year anniversary (or, in the first ten years, on the rate that would apply if the trust were tested at the date of distribution). It is then scaled by the number of complete calendar quarters since the last anniversary, divided by 40 — the number of quarters in a 10-year period.

In practice, this means an exit shortly after a 10-year anniversary attracts only a small charge, while one shortly before the next anniversary attracts a larger one. As with the periodic charge, the maximum effective rate is 6%, and the figure is often much less in real cases.

There is no exit charge on payments of income to beneficiaries — only on capital distributions.

Discretionary trusts can be useful in a number of estate planning situations. They are commonly used to hold assets for the benefit of children or grandchildren until they reach a suitable age, to protect inheritances from divorce or bankruptcy, to provide for a vulnerable family member, or to allow trustees to respond to changing family circumstances over time.

They are also used as part of will planning. A common example is a "nil-rate band discretionary trust" written into the will, which can preserve the deceased's £325,000 nil-rate band for future generations rather than allowing the assets to pass directly to a surviving spouse. This kind of planning has become less common since the introduction of the transferable nil-rate band in 2007, but is still relevant in particular cases — for example, second marriages or where the surviving spouse expects to remarry.

For a wider view of how gifting and other strategies fit into IHT planning, see How to Reduce Inheritance Tax Legally and Gifting Money to Family.

A discretionary trust is not a "set and forget" arrangement. Trustees have ongoing duties — to act in the best interests of the beneficiaries, to keep proper records, to file annual returns where required, and to pay any income tax, capital gains tax, or inheritance tax charges that arise within the trust.

Trusts also have their own income and capital gains tax regime, which is generally less favourable than the personal regime. Income above a small standard rate band of £500 is taxed at the trust rate of 45% (or 39.35% on dividends — note the dividend additional rate remains at 39.35% for 2026/27 even as basic and higher rates rise). The capital gains tax annual exempt amount for trusts is £1,500 for 2026/27 — half the £3,000 personal allowance.

Most trusts must register on HMRC's Trust Registration Service. Trustees who fail to register or to keep the register up to date can face penalties.