When planning your estate, a life interest will trust can provide income for loved ones while preserving capital for future beneficiaries. Understanding the tax implications and how these trusts work is essential for effective estate planning.
What is a life interest trust?
A life interest trust (sometimes called an Interest in Possession Trust) gives a beneficiary the right to receive all income from trust assets for a specified period – often their lifetime. Unlike discretionary trusts, trustees must pay out all income and cannot accumulate it within the trust.
Key features of life interest trusts:
- The income beneficiary (life tenant) has an absolute right to trust income
- Capital is preserved for future beneficiaries (remaindermen)
- Commonly used to provide for surviving spouses while protecting children’s inheritance
- Can include property, investments, or other income-producing assets
The life tenant receives income after taxes and expenses. Despite the name, a “life” interest doesn’t always last a lifetime – it might end at a specific age, on remarriage, or another triggering event. When the life interest ends, capital passes to the remaindermen.
A right to occupy property rent-free also creates a life interest, even though no income is generated. Trustees often have powers to advance capital to beneficiaries if needed, providing flexibility.
How does a life interest trust work?
Life interest trusts operate on a simple principle: separating the right to income from the right to capital.
Example: Sarah leaves her estate in a life interest will trust for her husband John, with their children as remaindermen. John receives all rental income from properties and dividends from investments during his lifetime. When John dies, the children inherit the capital.
This structure achieves several goals:
- John has financial security for life
- The children’s inheritance is protected
- Assets are shielded from potential remarriage claims
- Tax planning opportunities are available
Life interest trusts and inheritance tax
Understanding the relationship between life interest will trusts and inheritance tax is crucial for estate planning. The treatment depends on who receives the life interest and when it ends.
Inheritance tax on creation
Spouse exemption: Life interests for spouses or civil partners are exempt from inheritance tax, just like outright gifts.
Non-UK domiciled spouses: Limited to £325,000 exemption if the deceased was UK domiciled.
Other beneficiaries: Life interests for anyone else are chargeable transfers, potentially subject to 40% inheritance tax.
Tax on the life tenant’s death
When the life tenant dies, the trust assets are treated as part of their estate for inheritance tax purposes – even though they only received income, not capital.
The calculation includes:
- The life tenant’s personal assets
- The value of trust assets (or their share if partial)
- Less any debts
- Standard inheritance tax exemptions apply
Important advantage: Unlike discretionary trusts, life interest will trusts avoid 10-year anniversary charges and exit charges.
Life interest trust pros and cons
Before choosing a life interest will trust, consider these advantages and disadvantages:
Pros:
- Income security for the life tenant
- Capital protection for remaindermen
- No 10-year inheritance tax charges
- Spouse exemption available
- Can qualify for residence nil-rate band
- Protects against sideways disinheritance
Cons:
- Life tenant taxed on all income at their rates
- Limited flexibility once established
- Trust assets included in life tenant’s estate
- Administrative costs and complexity
- Potential family conflicts
- Capital gains tax implications
Life interest trust disadvantages in detail
While life interest trusts offer benefits, understanding the disadvantages helps you make informed decisions:
Inflexibility: Once created, the life tenant’s right to income is absolute. Trustees cannot withhold income even if the life tenant becomes financially irresponsible.
Tax burden: The life tenant pays income tax on all trust income at their marginal rates, which could push them into higher tax brackets.
No accumulation: Unlike discretionary trusts, income cannot be accumulated for future needs or reinvested to grow capital.
Relationship tensions: Conflicts can arise between life tenants wanting income and remaindermen wanting capital growth.
Administrative burden: Ongoing costs include trust tax returns, professional fees, and potential disputes requiring legal intervention.
What happens when a life interest ends?
A life interest can end during the life tenant’s lifetime through:
- Reaching a specified age
- Remarriage (if stated in the trust)
- The life tenant giving up their interest
- Other triggering events in the trust deed
Tax implications of ending a life interest
Assets leaving the trust: Usually a potentially exempt transfer (PET) – no immediate tax but the life tenant must survive seven years.
Exceptions:
- Transfer to spouse: Exempt
- Transfer to the life tenant: No tax
Trustees typically pay any tax due, though the life tenant’s estate may become liable.
Creating a new life interest: Immediately chargeable at 20% on amounts over the nil-rate band.
Life interest trust tax implications
Life interest will trusts face specific tax treatment across income tax, capital gains tax, and inheritance tax. Understanding these implications helps with planning.
Income tax treatment
Trust tax rates:
- Rental income: 20%
- Interest: 20%
- Dividends: 7.5%
These rates apply regardless of income levels. No personal allowances or dividend allowances apply.
Important: Trust management expenses cannot be deducted before calculating tax.
Life tenant taxation: The life tenant receives income with tax credits and includes it on their tax return. They can reclaim tax if their personal rate is lower than the trust paid.
Life interest trust capital gains tax
When trustees dispose of assets, capital gains tax may apply. Key points include:
- Annual exemption: £6,150 (half the individual allowance)
- Shared between multiple trusts from the same settlor
- Special reliefs may be available (Business Asset Disposal Relief, Investors Relief)
- Tax-free uplift on the life tenant’s death
Principal Private Residence Relief: Available if beneficiaries occupy trust property as their main home.
Life interest will trust cost
The costs of establishing and running a life interest will trust include:
Initial costs:
- Legal fees for will drafting with trust provisions
- Tax planning advice
- Asset valuation if needed
Ongoing costs:
- Annual trust tax returns
- Accountancy fees
- Investment management (if applicable)
- Legal advice for significant decisions
- Property maintenance (if property held)
While costs vary by complexity, life interest will trusts are generally less expensive to run than discretionary trusts due to simpler tax treatment and fewer compliance requirements.
Life interest trust explained – practical examples
Understanding how life interest trusts work in practice helps clarify their benefits:
Example 1 – Second marriages: David has children from his first marriage and marries Susan. His life interest will trust gives Susan the right to live in the family home for life, with the property passing to his children on her death. This balances Susan’s security with the children’s inheritance.
Example 2 – Vulnerable beneficiaries: Mary’s son has learning difficulties. Her life interest will trust provides him with income for life while protecting the capital from potential financial abuse. Professional trustees manage the investments.
Example 3 – Business assets: Tom owns a successful company. His life interest will trust allows his wife to receive dividend income while his children (who work in the business) ultimately inherit the shares.
Life interest will trust taxation – key considerations
When planning life interest will trust taxation, consider:
- The life tenant’s existing income and tax position
- Whether spouse exemption applies
- Potential for capital gains on trust assets
- The seven-year rule for lifetime transfers
- Available reliefs and exemptions
- Professional trustee requirements
Get expert advice on life interest will trusts
Life interest will trusts offer valuable estate planning opportunities but require careful consideration of tax implications and family dynamics. Our experienced private client team can help you understand whether a life interest will trust suits your circumstances.
We advise on:
- Choosing between life interest and discretionary trusts
- Inheritance tax planning strategies
- Protecting vulnerable beneficiaries
- Second marriage planning
- Business succession arrangements
- Wills and probate matters
Contact our specialist team on 020 3993 4988 or email wellers.wealth@wellerslawgroup.com