What is a spousal bypass trust?

A bypass trust is a term used to describe a discretionary trust which can be set up to receive a pension lump sum death benefit, with the surviving spouse as one of the beneficiaries.

One of the uses of these trusts is stop the death benefits falling into the surviving spouse’s estate. It allows the death benefits to pass to the next generation inheritance tax (IHT) free, while still allowing the spouse to make withdrawals from the trust.

Why are spousal bypass trusts used?

For more complex family circumstances where a simple nomination or expression of wish cannot achieve the desired outcome or if a payment may cause IHT issues if it is paid direct to a beneficiary.

To avoid or reduce the IHT on the survivor’s estate, though this has become much less common since pension freedoms came in April 2015, as flexi access drawdown benefits can be passed on to anyone IHT free. However, some older plans may not offer this flexibility.

Some pension plans such as Section 32 plans or retirement annuity contracts may not be written under trust.  A spousal bypass trust can be used to make sure any lump sum death benefits do not fall into the individual’s estate. 

When could a spousal bypass trust be used?

• to place any lump sum death benefits not already under trust in a trust
• to give control over who receives the benefits
• to control the way benefits are taken
• to pay care home fees
• for children under 18

How is a trust set up?

• The individual chooses the trustees, the spouse will normally be one.
• The individual sets up the trust and then nominates the trust as their preferred recipient of the death benefits.
• The trust names the beneficiaries. As it’s a discretionary trust, the trustees have the power to decide who the beneficiaries ultimately will be, but as they’re appointed by the individual, they should be closer to knowing the individual’s wishes on death and their circumstances at the time.

Most providers provide specimen forms that can be used. However, it's essential to speak to a trust expert when setting up a trust to ensure that it does exactly what it is intended to do. By the time the benefits are to be paid to the trust it is too late to fix any errors.

How are the death benefits paid to the trust?

Generally, pension scheme trustees or administrators have discretion as to who pension death benefit are paid. An individual can tell the scheme administrator/trustees, by completing a nomination form, who they’d like to receive the death benefits. If they want the lump death benefits to be paid to the trust, they will name the trust on the form (although some providers may have a special section on their form to cater for this).

How is a spousal bypass trust taxed?

Pension lump sum death benefits paid to a bypass trust will suffer a tax charge where the member died:

• after age 75, or
• under age 75 and either:
  
  • after the relevant two-year period, or
  • on lump sum benefits that exceed the deceased’s remaining lump sum and death benefit allowance

The special lump sum death benefits charge is applied. The charge is 45%.

More information can be found at:

• HMRC Pensions Tax Manual - PTM073010: Death benefits: lump sums: tax on authorised lump sum death benefits paid on or after 6 April 2016
• HMRC Pensions Tax Manual - PTM073200: Death benefits: lump sums: Taxation of an uncrystallised funds lump sum death benefit  

When income payments are made to the beneficiaries from the bypass trust, these will be subject to the normal rules in relation to taxation of income payments from a discretionary trust. 

A periodic inheritance tax charge may arise on each 10-year anniversary of the creation of the trust.

The calculation of the periodic charge is complex, but the effective rate of IHT will never be more than 6%, based on current tax rates.

The exit charge arises when capital leaves the trust and is advanced to a beneficiary. Again, based on the rates referred to, it can never be more than 6%.

The 10-year anniversary date for inheritance tax periodic charges may be different depending on the structure of the pension.

• Trust based – date the individual joined the pension scheme
• Contract based – date the payment to the trust or the date any benefits had been assigned to a trust.

Things to consider when setting up a spousal bypass trust

Individuals considering a bypass trust will need to balance the advantage of extra control and flexibility, against the potential 45% tax charge which applies to the lump sum paid to the bypass trust and the cost of the ongoing trust tax.

This can be a complicated area of trust and IHT law and specialist advice should always be taken.

So, although since April 2015 death benefits from a plan written under a trust are outside the individual’s estate for IHT purposes and can be passed through generations, for most clients, death benefit freedoms can give enough flexibility, but for those who wish more control or with more complex situations a trust may provide extra comfort for the individual.