Are bypass trusts still appropriate?

The current death benefit rules for pension schemes are very generous and allow great flexibility in terms of how benefits can be distributed. Providing appropriate nominations are in place benefits can be passed on within a tax-advantaged pension environment for generations, in many cases withdrawal will be tax-free for the beneficiary, and at worst taxed as income when paid to an individual.

Given these flexibilities, why would anyone want to use a bypass trust? Bypass trusts are discretionary trusts and as such the usual periodic and exit charges will apply, in addition to income tax and CGT. In a pension the investments are tax free.

The answer can be summed up in one word: control.

It is not uncommon that a pension scheme member may want to make provision for a spouse or dependant for their lifetime and then want any remaining funds to be passed on in a certain way on their subsequent death. For example Mr A is on his second marriage and wants his spouse (Mrs A the second) to be looked after, but on her death for funds to go to his children from his marriage with Mrs A the first. There is no way this can be catered for within a pension. On Mr A’s death the funds would go to Mrs A the second (if that was the decision made by the scheme administrator), but on her death the scheme administrator would only need to look at her wishes, not those of Mr A.

The other question we get asked is whether we, as scheme administrator, can place restrictions on how benefits are taken. This is most commonly for young adult beneficiaries, those who are in their late teens or early twenties, and the member wants to make provision for them, but not for them to have access to the whole fund. This simply isn’t possible under a pension. For under 18s the parent or legal guardian will control access, but once the child hits 18 it is theirs to do with as they wish.

A bypass trust can be useful in these situations as the member can appoint their own trustees and give clear instructions as to how they want funds distributed on their death and, crucially, beyond.

Where the member dies before age 75 there is no tax to pay when the pension death benefits are paid to the trustees of the bypass trust (subject to the lifetime allowance), and the trust tax charges may be a small price for the desired control.

The issue becomes more interesting when the member was over 75 at the time of their death. In these instances the scheme administrator must first deduct the special lump sum death benefit charge of 45% before paying the pension funds to the trust. However, this amount is not “lost” to HMRC forever. When a distribution is later made to a beneficiary of the trust a tax credit is attached to it for the amount of tax already paid.

As an example we have Mr Lee who dies aged 76 with a SIPP worth £300,000 which is paid to a bypass trust. The trustees will receive £165,000 with £135,000 going to HMRC.

Later a distribution is made to two beneficiaries for £35,000 each. No income tax is payable on the distributions and the beneficiaries each get a tax credit for the 45% tax already paid. Effectively these payments are treated as each beneficiary receiving £63,636.36 with tax paid at 45% - so the tax credit is worth £28,636.36. This tax credit can then be used to offset their income tax liability for the tax year.

For those with an income tax bill higher than the credit, the whole credit will be used and the issue of the 45 per cent tax on funds going from the pension to the bypass trust is effectively neutralised. If the beneficiary does not have sufficient income in the tax year to have a tax bill of more than the credit, then HMRC have now confirmed that the difference can be reclaimed.

In practice, then, bypass trusts can still be just as appropriate as prior to pension freedoms.

Senior Technical Consultant

Lisa is an Economics graduate who has been in the financial services industry since 2003. Prior to joining AJ Bell in 2014 she spent nine years working in senior technical and consultancy roles at a major SIPP and SSAS provider. Lisa is part of our Technical Team, responsible for providing regulatory and technical analysis to the business and outside world. She is also a regular speaker at adviser events.