A look at spousal bypass trusts, how they work and some of the issues involved.
- An individual can place their pension lump sum death benefits into a discretionary trust, allowing the spouse to benefit without these benefits forming part of the survivor’s estate on death.
- Provided any pension lump sum death benefits are distributed from the pension scheme within two years (of the scheme being notified of the member’s death), any benefits should not normally be subject to inheritance tax.
- A trust can be set up in one of two ways: 1) create a separate pilot trust or 2) assign the right to the death benefits under an integrated personal trust.
- Using bypass trusts can be an effective way to provide spousal benefits while mitigating tax on the estate
What is a spousal bypass trust?
An individual can place their pension lump sum death benefits into a discretionary trust, allowing the spouse to benefit without these benefits forming part of the survivor’s estate on death.
Once in trust, the trustees can make income and/or capital payments to the spouse or other beneficiaries, as well as making loans available to the spouse.
Any loans would be repayable out of the spouse’s estate on death, thus reducing the value of their estate for inheritance tax (IHT) purposes (i.e. treated as a debt on their estate).
How is a trust set up?
An individual can set up a trust in one of two ways:
- Create a separate pilot trust (a discretionary trust established in advance with minimal assets, intended to receive the death benefit)
- Assign the right to the death benefits under an integrated personal trust
How are lump sum benefits paid into a trust?
The individual can either (depending on the type of pension scheme and scheme rules):
- Draft a letter or complete a nomination of beneficiaries form letting the pension scheme trustees know their intention for the lump sum death benefit to be paid into a separate trust; or
- Give a binding nomination to the trustees (directing benefits to be paid into a separate trust)
How are any pension lump sum death benefits taxed prior to entering the trust?
Any lump sum paid into the trust on death prior to age 75:
- Would be paid into the discretionary trust free of income tax.
This diagram illustrates the potential options and tax implications from lump sum death benefits paid from defined contribution (DC) schemes.
Any lump sum paid on death on or after age 75:
- Would incur a 45% special lump sum death benefit (SLSDB) charge, if paid into a discretionary trust, which applies to payments other than individuals, for example a trustee.
- Where this is subsequently paid out to a beneficiary, they are able to claim a tax credit of the difference paid between the trust rate and their marginal rate.
How are lump sum death benefits treated for tax once in the trust?
If a discretionary trust is set up which receives any lump sum death benefit originating from a registered pension scheme, then they will fall under the relevant property regime and will potentially be subject to periodic and exit charges.
Timing of periodic charges:
Where a lump sum death benefit is paid from a pension scheme into a trust:
- The timing of the periodic charge, in terms of the ten-yearly period, will depend on whether or not the scheme has discretionary disposal.
- It is possible for a lump sum death benefit to be treated as a separate settlement for IHT.
What type of lump sum death benefit is treated as a separate settlement?
For pension schemes that have discretionary disposal:
- Normally trust based schemes, but also SIPPs and some personal pensions, where the trustees or scheme administrator has ultimate discretion,
- These will be treated as a separate settlement.
- Therefore the periodic charge is based on the date the individual first became a member of the pension scheme and not the date the lump sum death benefit monies entered the bypass trust.
For pension schemes without discretionary disposal:
- Some personal pensions and older style contracts, such as s32 buy out plans,
- Their periodic charge calculation will be based on the date the lump sum death benefit monies are paid into the pilot trust (or the date they were assigned to the integrated personal trust).
- Therefore, this will be the date used to determine the first ten-yearly anniversary to which any periodic charge calculation will be based.
Using a discretionary trust with pensions can help clients:
- Looking to provide an effective way to provide spousal benefits while mitigating tax on their estate
- Looking to retain some form of discretion over to whom and how any benefit is paid, once it’s in trust
- Looking to provide wider benefit options than that available within a beneficiary’s flexi-access drawdown, for example, loans to a spouse