Bypass trusts

When the pension freedoms were announced back in George Osborne’s Budget of March 2014, the appeal of discretionary bypass trusts, commonly referred to as spousal bypass trusts, was dramatically reduced.

The new rules meant many more people could have the option to receive a pension income from the deceased member’s defined contribution pension fund, as the restriction to dependants was relaxed.

So why would anyone still want to use a bypass trust? To answer that, we need to first look at what can – and can’t – be done when passing funds on within a pension.

Passing funds on within a pension

Current legislation allows the pension member to nominate any individual, trust or entity to receive their remaining pension funds on their death (subject to scheme rules). Under most defined contribution pensions, the scheme administrator will exercise their discretion when deciding who should receive the funds. In most instances, this means the funds will remain outside the deceased’s estate and no Inheritance Tax (IHT) will be payable.

The scheme administrator should consider any nomination made by the member, and any dependents, whether nominated or not. If the decision is to pay funds to a dependant or nominee, rather than a trust or other entity, that individual will then have the choice of how to take the benefits. Most defined contribution schemes will offer the option of a lump sum payment, purchasing an annuity, or using the funds for a beneficiary’s flexi-access drawdown. Even if the scheme doesn’t have the facility to offer drawdown itself, the statutory permission override put in place at the time of pension freedoms should mean it is possible to transfer beneficiary’s flexi-access drawdown to a scheme that does.

The important point to note here is that it is down to the individual beneficiary themselves as to what form they would like to take the inherited funds in. This is not something the member can dictate when making their nomination or leaving an expression of wish. We have been asked on many occasions if the member can nominate a beneficiary, with instructions that they can only use the funds for an income and not take it all as a lump sum. This is simply not possible within the rules.

It is also worth noting what happens when that beneficiary dies. If the beneficiary has chosen the flexi-access drawdown option and there are still funds remaining on their death, it becomes their choice as to who to nominate to receive them when they are gone (again, subject to scheme administrator discretion). The original scheme member who built up the funds has no say where they go.

When is this an issue?

If you have a straightforward family situation and are leaving funds to beneficiaries the member perceives as responsible, then passing funds on within a pension is likely to be the best option. Funds can remain within the pension tax-wrapper to benefit from compound tax-free growth. If the member died before age 75, withdrawals will be free of Income Tax whenever taken; even where death occurred after the 75th birthday – so tax is payable – the withdrawals can be managed as appropriate to minimise Income Tax liability.

A trust may be more of interest where the member has complicated family arrangements and/or they want to provide for people without giving them immediate access to a large sum of money – for whatever reason that may be.

How a discretionary bypass trust can help

If instead of nominating the individuals directly, the member nominates the discretionary trust to receive the death benefits, then more control can be exerted. The member can choose the trustees and give them instructions as to how the funds should be distributed.

The second family scenario

Member has adult children from their first marriage, is on their second marriage at the time of death and has stepchildren. They nominate their (second) spouse to receive death benefits.

Under a pension, when the survivor dies, they choose who gets any residual funds – and could choose their own children over the original member’s adult children who would then get nothing. It could also be that the survivor marries again and leaves the funds to the new spouse.

If a trust was used instead, the member could instruct the trustee to provide an income for the survivor in their lifetime, with any residual funds going to the member’s children on their death.

The beneficiary who needs protecting

Member wants to leave funds to provide for a beneficiary but is reluctant to give them access to a large sum of money in one go. This could be for younger beneficiaries or those who lack capacity but could include those who have a history of money problems.

With the trust option, an income could be provided for such beneficiaries, or ad hoc payments made to them for purposes as defined by the member and at the trustees’ discretion. Under a pension, there is simply not this option – the beneficiary has access to the funds or not at all.

Taxation

In terms of tax-efficiency, keeping funds within the pension will always be the best option. There is a cost to the extra control given under the trust option. However, the level of the cost will depend on the circumstances.

When the trust is created, this will give rise to a transfer of value by the Settlor (the member) for IHT purposes. It is usual to establish the trust with just a nominal gift of £10, to fall within the Settlor’s available annual exemption. Provided no assets are added to the trust while the Settlor is alive, there will be no IHT charges in their lifetime.

The payment of death benefits from the pension to the bypass trust will be tax free if:

• the member died before their 75th birthday; and
• the payment is made within two years of the death (or the date the scheme administrator was aware, or should reasonably have been aware, of the death); and
• the funds have already been crystallised or there is sufficient remaining lifetime allowance available.

If the member dies on or after their 75th birthday, or the death benefits are paid to the trust more than two years after the scheme administrator knew of the death, then the special lump sum death benefit charge of 45% will apply. The scheme administrator will deduct this amount before paying the balance to the trust. It is important to note that there is an associated tax credit with this payment – see below for more information.

As a discretionary trust, special IHT charging rules apply after the death of the Settlor. There may be IHT charges on every 10-year anniversary of the trust (the periodic charge) or whenever property leaves the trust (the exit charge).

It is important to note that when property moves between different discretionary trusts, the trusts are treated as one for the purpose of the 10-year periodic charge and exit charge, with the start date being when the first trust began. In this instance the member will be treated as creating the trust when they joined the pension scheme. If the pension scheme paying out the death benefits received transfers-in, it will be the date of the first pension scheme that will be the start date.

The calculation of IHT periodic and exit charges can be complex, especially when there have been multiple transfers into the pension from several different originating schemes. It may be necessary to seek specialist advice, but the maximum liability will be 6% of the value of the trust property at the 10-year anniversary. Frequently it will be much less or even nil.

Income generated within the trust is also subject to tax. The first £1,000 of gross income is taxed at standard rate – i.e. 7.5% on dividends and 20% on other income. Anything above this is taxed at the special trustee rate of 38.1% on dividends and 45% on other income.

When trust assets are sold, the process for calculating gains is the same as for individuals, but any tax will be payable at trust rates of CGT (20%, or 28% for residential property). The trustees are only entitled to half the individual annual CGT exempt amount (so £6,150 for the current tax year).

Claiming the tax credit

When the trust makes distributions to the beneficiaries, there is a tax credit attached reflecting the 45% rate already paid. This can be offset against the beneficiary’s other income in the tax year.

The amount that can be claimed is the proportion of the tax charge that is attributable to the amount received by the trust beneficiary. For example, if two beneficiaries each receive 50% of the lump sum death benefit received by the trust, they can each set off against their own Income Tax liability 50% of the tax charge paid by the scheme administrator.

For example:

The scheme administrator will provide the trustees with the relevant information that they must pass on to the beneficiary for them to make the claim. The beneficiary must then account for the gross amount of lump sum death benefit in their Self-Assessment return, or they can use the R40 repayment claim form.

Where the tax paid exceeds the total Income Tax liability for the year, HMRC will repay the difference.

Price of control

Although the tax credit is designed so that the tax on the lump sum death benefit is paid at the individual’s marginal rates, as if they had received the payment from the pension scheme directly, the control the trust gives will come at a cost.

There is no time limit for onward payment of the lump sum death benefit from the trust to the individual. However, the lost compound growth on the 45% paid to HMRC when the death benefits are transferred to the bypass trust will become increasingly larger than the 45% tax credit that can be claimed when payments are eventually made to beneficiaries.

Whether it is a cost worth paying will be down to individual circumstances.

This article was previously published by FT Adviser