Discounted Gift Trusts, often referred to as DGTs, are a way to avoid inheritance tax, and protect your wealth while keeping access to a regular income.
In today’s article, you’ll learn about how this type of trust works for those seeking to reduce the level of taxes levied on their estate when they pass.
Of course, it’s important to note that this article is for educational purposes and doesn’t constitute advice. Inheritance tax is a complex issue, and each individual’s situation is unique. Seek professional guidance before making any decisions.
Discounted Gift Trusts & inheritance tax, explained
In summary, Discounted Gift Trusts are often used as part of a wider inheritance tax planning strategy. However, they are not designed to eliminate tax in isolation. Their role is to restructure how wealth is passed on while allowing the individual to retain a dependable income for life.
Key points to understand include:
- Part of the gift may be treated as outside the estate immediately
- The remaining value is subject to the seven-year rule
- Any growth on trust assets sits outside the estate
- The discount depends on age, health, and income chosen
- Inheritance tax outcomes are not guaranteed
From an inheritance tax perspective, the benefit comes from combining long-term planning with survivorship. Discounted Gift Trusts work best when introduced early, alongside other allowances, trusts, and estate planning measures, rather than being relied upon as a last-minute solution.
If you’re brand new to this topic, we’ve created an in-depth guide that covers the most important areas of Discounted Gift Trusts. In that guide, we focus on what DGTs are, how they work, and the pros, cons and examples of them in practice.
How Discounted Gift Trusts are used to avoid inheritance tax
Many people want to pass money on to their children, but are unsure whether they’ll need it later in life. A Discounted Gift Trust offers a middle ground and, as a result, is one of the ways to avoid inheritance tax. You can take regular withdrawals from the trust, while potentially cutting your estate’s inheritance tax position.
Here’s how they work in practice:
- You transfer a lump sum into a trust set up by an IHT planner.
- You retain the right to receive a fixed annual amount from the trust for life.
- The leftover value could be a gift and may be outside your estate after seven years.
- HMRC applies a discount to your gift, based on your age and health
- This could reduce the inheritance tax impact straight away
- The discounted amount is never counted as part of your estate again.
This approach appeals to people with significant savings or investments who want to gift money but aren’t ready to give up access completely.
The level of ‘discount’ is calculated by the insurance company based on life expectancy.
Example of how DGTs can reduce IHT & provide an income
Priya, aged 66, had £300,000 in her savings accounts. In a nutshell, she wanted to pass on these assets to her children. She placed these assets into a Discounted Gift Trust and chose to receive £12,000 a year. The income gave her peace of mind. Additionally, the discounted value meant part of her estate was no longer included in her inheritance tax calculations straight away.
Why the discount matters
The name can be misleading; you’re not getting a discount in the retail sense. It’s a notional value based on how much income you’re expected to draw before death. That sum is considered to still be yours and remains outside the gift calculation.
The practical outcome?
- A lower initial gift value for inheritance tax purposes
- A faster reduction of your estate’s taxable value
In effect, subject to underwriting, the discount protects a portion of the gift from inheritance tax immediately. This is why DGTs are particularly suitable for those in good health, as a higher life expectancy leads to a larger discount.
Example of using a DGT to avoid inheritance tax
Jean-Claude, a gentleman in his 50s, set up a Discounted Gift Trust with £200,000. Based on his age and current level of health, the insurance company applied a £60,000 discount. That portion was excluded from his estate immediately. Lastly, the remaining £140,000 may fall outside his estate after seven years, assuming he lives that long.
The role of offshore investment bonds
Offshore investment bonds are a popular funding method for this type of trust.
They allow the underlying investment to grow tax-deferred while providing a steady income stream. If you’re exploring tax-efficient IHT planning strategies, take a look at our guide to Offshore Investment Bonds.
What happens to a DGT on death?
When you die, the trust continues, and the remaining assets pass to your chosen beneficiaries outside of your estate, assuming the seven-year rule has passed for the gift portion.
Here’s what happens next:
- Your right to the income ends at death
- The remaining trust assets go to the beneficiaries
To summarise, if death occurs within seven years, some or all of the gift may still be subject to inheritance tax
It’s worth noting that if you die within seven years of setting up the trust, only the non-discounted portion of the gift may be taxable.
The rest (the ‘discount’) is not included. All in all, these details are well worth noting.
Example of what happens to a DGT when you die
Arjun died six years after setting up his Discounted Gift Trust. The £75,000 discounted portion stayed outside his estate. The remaining gift was still included, though his estate qualified for taper relief. His daughter received the trust proceeds without needing probate, as the trust continued without interruption.
Applying the 7-year rule for inheritance tax
When a Discounted Gift Trust is set up, the value transferred into the trust is treated as a lifetime gift for inheritance tax purposes, which means the 7-year rule becomes relevant to how much of the gift is ultimately included in the estate.
Key points to understand include:
- The initial gift is classed as a potentially exempt transfer
- Surviving seven years can remove remaining value from the estate
- The discounted portion may be excluded immediately
- Only the non-discounted value is tested over time
- Early planning improves outcomes
In practice, the seven-year rule reinforces the importance of timing. Discounted Gift Trusts are most effective when established well before inheritance tax becomes an immediate concern, allowing sufficient time for the rules to take full effect.
The role of taper relief
Furthermore, taper relief is another element of inheritance tax planning. In summary, it applies if death occurs between three and seven years after the gift is made. It does not reduce the value of the gift, but it can reduce the inheritance tax payable on that gift.
Key considerations include:
- Relief increases the longer the person survives
- It applies only after the nil rate band is used
- It affects tax payable, not the gift value
- It does not apply within the first three years
- It is not guaranteed to remove all tax
For Discounted Gift Trusts, taper relief can soften the tax impact if death occurs earlier than expected. However, it should be viewed as a fallback rather than a planning goal, as full effectiveness depends on survival beyond the seven years.
When a Discounted Gift Trust may be a good way to reduce inheritance tax
These trusts aren’t for everyone, but they can be a useful part of inheritance tax planning if:
- You’re in good health and want to reduce your estate now
- You have enough other income to live on, with the DGT acting as a top-up
- You want to maintain access to some capital, but pass the rest on tax-efficiently
- You’re comfortable giving up access to the remaining capital (you can’t dip back in)
For those who meet the criteria, the benefits can be significant. But the structure is rigid, so it needs to be planned properly with professional advice.
Example of using DGTs to avoid inheritance tax
Taylor had no children but wanted to support their niece. They used a DGT to pass on £100,000 while keeping an annual income of £4,000. The trust structure gave them control during their lifetime and helped reduce inheritance tax exposure over time, assuming their health stayed stable.
Potential drawbacks of using Discounted Gift Trusts for IHT mitigation
Some people are drawn to the inheritance tax savings without fully understanding the long-term consequences. Here are a few things to watch for:
- You can’t change your mind once the trust is set up
- There’s no access to the capital beyond the agreed income
- If your circumstances change, the trust won’t adapt
- It may affect your ability to claim certain benefits or allowances
This isn’t a flexible product; it’s designed for a specific purpose. If that purpose no longer fits, you could be locked into something that doesn’t work for you.
Looking at other trust options?
This article has focused on how DGTs help reduce inheritance tax while allowing a fixed income. But they’re not the only trust structure worth considering:
- Loan Trusts allow full access to capital, while the growth falls outside your estate
- Flexible Reversionary Trusts allow optional withdrawals and staged wealth transfer
- Some trusts suit cautious planning, others offer more control and other benefits
To explore all three in one place, read our guide on how to use trusts to avoid inheritance tax, and see which might suit your long-term goals.
Related reading: Discounted Gift Trusts Vs. Loan Trusts
FAQs
Discounted Gift Trusts tend to suit people in good health who want to reduce their estate for inheritance tax but still receive a regular income. Lastly, they are often used by those with stable finances who are unlikely to need the original lump sum again in future.
Withdrawals from these trusts are usually treated as a return of capital, as opposed to income. In summary, this means there is no immediate tax to pay, and nothing to report to HMRC unless your situation changes, i.e. the size of your taxable estate.. It is sensible to keep clear records in case future tax rules or your personal circumstances affect the outcome.
If you die within seven years, the discounted portion is excluded from your estate. The rest may still be counted, depending on how much time has passed. If more than three years have passed, taper relief could apply and may reduce the inheritance tax due on that amount.
No. Once the trust is in place, the terms are fixed. You cannot access the remaining capital or change the income level. This makes it important to be sure the arrangement suits your long-term plans before going ahead.
No, this is a very important point to understand. You will need a qualified inheritance tax planner to create the trust and arrange the investment bond. They will make sure the trust fits your overall estate plan and that everything is handled correctly under HMRC rules.