What is a spousal bypass trust?
It’s a discretionary trust where an individual can place their lump sum death benefits. It is sometimes called a flexible trust.
- It’s a discretionary trust where a individual can place their lump sum death benefits into it.
- For more complex family circumstances where a simple nomination or expression of wish does not cover the situation.
- The individual sets up the trust and nominates the trust as their preferred recipient of the death benefits.
- Pension lump sums paid to a bypass trust will suffer a 45% tax charge if the pension scheme member dies after age 75.
- The 45% tax charge can be offset for the tax already paid.
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 these flexibilities.
Some pension plans such as Section 32 plans or retirement annuity contracts may not be written under trust. As 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 are the death benefits paid to the trust?
The standard death benefit nomination form is used and details of the trust are put there. Some providers may have a special section on their form.
How is a trust set up?
- The individual chooses the trustees, the individual 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 you can use. However, it's essential that you speak to a trust expert when setting up a trust to ensure that it does exactly what you intend it to do. By the time the benefits are to being paid to the trust it is too late to fix any errors or defects.
How is a spousal bypass trust taxed?
Pension lump sum death benefits paid to a bypass trust will suffer a 45% tax charge if the pension scheme member dies after age 75. Before age 75 it is paid tax-free unless a lifetime allowance charge is payable.
The tax situation for distributions from the trust are similar, where the distributions are from a fund that was from a pre age 75 death they are income tax free.
Where the death was post age 75 distributions from the trust will be treated as income and be added to the beneficiary’s income for that tax year. For tax purposes, a pension lump sum death benefit is treated as if it was income for that tax year. If 45% tax was deducted this can be used to offset any income tax due.
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 Inheritance Tax 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 IHT 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.
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 if the individual dies after age 75, 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.
The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.
All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.