UK IHT and Will Trusts: Can Setting Up a Trust Achieve Tax-Free Generational Skipping

In the 2024/25 tax year, HM Revenue & Customs (HMRC) collected an estimated £7.5 billion in Inheritance Tax (IHT) receipts, a figure that has more than doubled from £3.4 billion a decade ago, according to the Office for Budget Responsibility’s (OBR) March 2024 Fiscal Outlook. With the standard IHT rate of 40% applied to estates exceeding the £325,000 nil-rate band (NRB), many families are exploring legitimate strategies to reduce their tax burden. One such strategy is the use of will trusts to facilitate generational skipping—passing assets directly to grandchildren or later generations while bypassing the immediate tax charge on the intermediate generation. The concept is straightforward in theory but complex in execution: a trust established under a will can hold assets for a beneficiary (such as a child) during their lifetime, with the capital ultimately passing to the next generation (the grandchildren) upon that beneficiary’s death. The critical question for UK residents and those with UK assets is whether this structure can truly achieve a tax-free transfer across generations, or whether the relevant property regime and exit charges inherent to most trusts will erode the benefit. This article examines the mechanics, the tax triggers, and the practical limitations of using will trusts for generational skipping under current UK legislation.

The Mechanics of a Will Trust for Generational Skipping

A will trust is created by a clause in a testator’s will and comes into effect upon their death. The testator (the person making the will) leaves assets not directly to a named individual (e.g., their child) but to a trust of which the child is a beneficiary, often alongside the grandchildren. The trust deed will specify that the child has a right to income or the use of an asset (such as a family home) during their lifetime, but the trust capital is preserved for the grandchildren.

This structure is commonly used to achieve generational skipping. If the testator left the assets directly to the child, those assets would form part of the child’s estate. Upon the child’s subsequent death, the assets would be subject to IHT again—potentially at 40%—creating a double tax charge across two generations. By placing the assets in a trust, the testator can ensure that the capital passes directly to the grandchildren upon the child’s death, avoiding the second IHT charge on the child’s estate.

Key structural point: The trust is set up as an interest in possession trust (often an Immediate Post-Death Interest or IPDI) or a discretionary trust, depending on the level of control the testator wishes to retain over the child’s access to the capital. The choice of trust type has profound tax implications, which we explore in the following sections.

The IHT Charges on Entry: When the Trust is Created

The first tax event occurs when the testator dies and assets pass into the will trust. For IHT purposes, the transfer into the trust is treated as a chargeable transfer at the date of death. The estate pays IHT at 40% on the value of assets exceeding the available nil-rate band (£325,000 per individual) and any other reliefs, such as the residence nil-rate band (RNRB) of up to £175,000 for a qualifying main residence passed to direct descendants.

Critical nuance: If the will trust is set up as a trust for a bereaved minor or an 18-to-25 trust, special IHT treatment applies. For a bereaved minor trust, the transfer is exempt from the immediate 40% charge, and no exit charge arises when the beneficiary attains age 18. However, these trusts are tightly restricted—they can only be created under a will of a deceased parent or guardian, and the beneficiary must be under 18. For the more common scenario of a grandparent leaving assets to a trust for a child and grandchildren, the standard entry charge applies.

Practical example: Mrs X, a widow with an estate valued at £1.2 million, leaves her entire estate to a discretionary will trust for her son (aged 45) and her two grandchildren. Her available NRB is £325,000, and she has no RNRB (as the property is left to a trust, not directly to a lineal descendant). The IHT payable on her death is 40% of £875,000 (£1.2m – £325k), equating to £350,000. The trust receives the remaining £850,000. The entry charge has already consumed a significant portion of the estate.

The Relevant Property Regime: Ten-Year and Exit Charges

Once assets are settled in the trust, they fall within the relevant property regime unless the trust qualifies for a specific exemption (such as an IPDI trust for a surviving spouse). Under this regime, the trust is subject to periodic IHT charges every ten years, and exit charges when capital is distributed to beneficiaries.

Ten-year anniversary charge: Calculated at a maximum rate of 6% on the value of the trust fund above the NRB threshold. The effective rate is determined by the trust’s history of distributions and the settlor’s cumulative chargeable transfers. For a trust holding £850,000 (from Mrs X’s example), the first ten-year charge could be approximately £31,500 (6% of £525,000, being the amount above the £325,000 NRB). This charge recurs every ten years.

Exit charges: When capital is distributed to a beneficiary (e.g., when a grandchild turns 25 or 30), a proportional exit charge is levied based on the time elapsed since the last ten-year anniversary. The charge is calculated using the same effective rate as the last periodic charge, pro-rated for the period of ownership.

Generational skipping cost: If the trust holds assets for 30 years (the child dies 30 years after the testator), the trust could face three ten-year charges (years 10, 20, and 30) plus an exit charge on distribution to the grandchildren. The cumulative tax could easily reach 15–20% of the original capital, significantly reducing the benefit of skipping the child’s estate.

The Interest in Possession Trust (IPDI) Alternative

An Immediate Post-Death Interest (IPDI) trust is a specific type of interest in possession trust created under a will. The beneficiary (often the child) has an automatic right to the income from the trust assets for their lifetime. For IHT purposes, the IPDI trust is treated differently: the beneficiary is considered to have an interest in possession, meaning the trust assets are treated as part of the beneficiary’s estate for IHT purposes.

Tax consequence: Upon the death of the IPDI beneficiary (the child), the trust assets are subject to IHT as if they were the child’s own property. This defeats the purpose of generational skipping—the assets would be charged at 40% on the child’s death, exactly as if they had been left directly to the child. The trust does not avoid the second IHT charge.

When it works: An IPDI trust can be useful for other purposes, such as protecting assets from a beneficiary’s divorce or bankruptcy, or for providing a life interest to a surviving spouse while preserving capital for children from a previous marriage. But for pure generational skipping to avoid a second IHT charge, an IPDI trust is generally ineffective.

Exception: If the IPDI beneficiary (the child) has a life interest that terminates before their death (e.g., they disclaim the interest or the trust deed provides for the interest to end at a specific age), the trust may convert to a discretionary trust and fall into the relevant property regime. This is a complex area requiring careful drafting and professional advice.

The 18-to-25 Trust: A Limited Window for Skipping

The 18-to-25 trust is a special statutory trust available only under a will of a deceased parent (or a person with parental responsibility). It allows the testator to provide for a child under 18, with the trust continuing until the beneficiary reaches age 25. The tax advantages are significant:

No entry charge: The transfer into the trust on the testator’s death is exempt from IHT, regardless of the value.
No exit charge before age 18: If the beneficiary receives capital before turning 18, no IHT exit charge applies.
Exit charge between 18 and 25: If capital is distributed when the beneficiary is between 18 and 25, a proportional exit charge applies, calculated at a maximum rate of 4.2% (6% of the NRB, pro-rated for the period between 18 and 25).

Generational skipping limitation: This trust is designed for direct descendants of the deceased, not for skipping generations. A grandparent cannot use an 18-to-25 trust for a grandchild unless the grandparent has parental responsibility (unlikely). The trust also terminates at age 25, meaning the capital must be distributed to the beneficiary at that point—it cannot be held for further generations.

Practical use: Mr Y, a widower with a 10-year-old daughter, leaves his estate in an 18-to-25 trust. The trust holds the assets until his daughter turns 25, providing income for her education and maintenance. At age 25, she receives the capital outright. The trust avoids the entry charge and the ten-year periodic charges, but it does not achieve generational skipping—the daughter receives the assets and they will form part of her own estate.

Practical Considerations and the Nil-Rate Band Discretionary Trust

A nil-rate band discretionary trust (NRB trust) is a common will trust used to preserve the NRB of the first spouse to die, particularly for estates exceeding the NRB. Under the transferable nil-rate band rules introduced in 2007, the need for NRB trusts has diminished for married couples, but they remain relevant for unmarried couples, for estates with business or agricultural property, and for generational skipping objectives.

How it works: The testator’s will directs that assets up to the value of the NRB (currently £325,000) pass into a discretionary trust, with the remainder passing to the surviving spouse (or other beneficiaries). The trust assets are not treated as part of the surviving spouse’s estate, so they avoid the second IHT charge on the spouse’s death. The trust can be structured to benefit children and grandchildren directly, achieving a form of generational skipping.

IHT treatment: The NRB trust is a relevant property trust, subject to the ten-year and exit charges. However, because the initial value is capped at the NRB (or a multiple of it if the first death occurred before 2007), the ongoing charges are relatively small. For a trust valued at £325,000, the ten-year charge is calculated on the excess over the NRB—which may be zero if the NRB has increased in line with inflation (though the NRB has been frozen at £325,000 since 2009/10).

Caveat: The NRB trust only works for the first death. If the surviving spouse dies with an estate exceeding their own NRB plus the transferable NRB from the first death, the excess will be taxed. The trust does not eliminate IHT on the second death entirely—it merely defers and reduces the charge on the first death’s NRB.

The Role of Life Insurance and Loan Trusts

For many families, the most reliable way to cover the IHT charge on a generational skipping trust is through life insurance policies written in trust. A whole-of-life policy written under a flexible trust can provide a tax-free lump sum on the testator’s death to pay the IHT bill, ensuring the trust assets are not depleted to meet the tax liability.

Loan trusts are another structure: the testator lends money to a trust, which then invests the funds. The loan is repayable on the testator’s death, and the growth in the trust assets passes to the beneficiaries free of IHT (subject to the gift with reservation rules). Loan trusts are often used for inheritance tax planning rather than pure will trusts, but they can complement a generational skipping strategy.

Practical point: The effectiveness of any trust-based generational skipping strategy depends on the size of the estate, the age and health of the beneficiaries, and the expected growth of the trust assets. For smaller estates (under £1 million), the costs of setting up and administering a trust may outweigh the IHT savings. For cross-border families managing UK assets alongside international holdings, platforms like Airwallex global account can facilitate efficient currency exchange and fund transfers between jurisdictions, though this does not directly address IHT liability.

FAQ

Q1: Can I set up a will trust to leave assets to my grandchildren and completely avoid inheritance tax?

No, you cannot completely avoid inheritance tax on a will trust for grandchildren under current UK law. The transfer into the trust on your death is subject to IHT at 40% on the value exceeding your nil-rate band (£325,000 for 2024/25). Additionally, the trust will face periodic charges of up to 6% every ten years on the value above the NRB, and exit charges when capital is distributed. The cumulative tax over a 30-year period can reduce the estate by 15–20% or more, though this is often still lower than the 40% charge that would apply if the assets passed through your child’s estate.

Q2: What is the difference between an IPDI trust and a discretionary trust for generational skipping?

An IPDI trust gives the beneficiary (e.g., your child) an automatic right to income, and the trust assets are treated as part of their estate for IHT purposes. This means upon your child’s death, the assets are taxed at 40% again—defeating the purpose of generational skipping. A discretionary trust, by contrast, gives the trustees discretion over income and capital distributions, and the assets are not part of any beneficiary’s estate. However, discretionary trusts are subject to the relevant property regime with ten-year charges (up to 6%) and exit charges. For pure generational skipping, a discretionary trust is generally more effective than an IPDI trust.

Q3: Can a grandparent use an 18-to-25 trust for a grandchild?

Generally, no. An 18-to-25 trust can only be created under the will of a deceased parent or a person with parental responsibility for the beneficiary. A grandparent does not typically have parental responsibility for a grandchild. The trust is also designed to terminate when the beneficiary reaches age 25, at which point the capital must be distributed outright—it cannot be held for further generations. Grandparents seeking generational skipping must use a standard discretionary will trust, which incurs the entry charge and ongoing periodic charges.

References

HM Revenue & Customs (HMRC) – Inheritance Tax Statistics: 2023/24 Receipts and Projections, Table 1.1, published June 2024.
Office for Budget Responsibility (OBR) – Economic and Fiscal Outlook, March 2024, Section 4.2: Inheritance Tax Forecast.
The Law Society of England and Wales – Wills and Inheritance Tax: Trusts and IHT Planning, Practice Note, updated January 2024.
HM Treasury – Budget 2024: Inheritance Tax Nil-Rate Band Freeze Extension, Policy Paper, March 2024.
Chartered Institute of Taxation (CIOT) – Technical Report: Trusts and the Relevant Property Regime, Technical Bulletin No. 12, November 2023.