Spousal Bypass Trust Explained.
Background: Pension Benefits On death
The death benefits of a pension fund can in most cases be passed to loved ones, via an “expression of wish” form to your spouse or other loved ones with a charge to inheritance tax.
If you leave the pension fund to your spouse, this means that when they die, those funds will form part of your partner’s estate on their death and could then be subject to inheritance tax.
Some advisers suggest that use of a Spousal Bypass Trust to effectively “by pass” loved ones and pass the money to a family trust.
Explanation and Benefits of a Bypass Trust
A bypass trust is an irrevocable discretionary family trust.
Where you use a bypass trust then any lump sum death benefits from your pension fund are passed to the trust and held for the benefit of your family. The aim is to minimise the charge to Inheritance Tax.
Whilst the payment of any uncrystallised (not taken yet) pension benefits is usually made outside the member’s estate and not subject to Inheritance Tax, if the benefits are passed to your surviving spouse and they form part of their estate and they then die, then the money is potentially subject to 40% Inheritance Tax.
A discretionary trust has a wide class of beneficiaries including surviving spouse and children.
Your surviving spouse can still benefit from income, capital and loans from the trust at the discretion of the trustees. The only difference is that the money is not inside your partner’s estate for Inheritance Tax purposes.
If lump sum death benefits were paid at the discretion of the pension trustees then any non- crystallised fund would be Inheritance Tax free and not part of your estate.
If the death benefits are paid from the pension to the bypass trust then it is no longer in a pension and will be subject to discretionary trust taxation. This means 10 year periodic and exit charges (see taxation of discretionary trusts).
Pensions are usually trust based so the date for the first 10 year charge starts on the date you join the pension scheme.
However, whilst you are still alive there is no periodic charge due. The 10 year periods continue to run but there is no Inheritance Tax payable as there is no value at the time in the trust – it is still in the pension.
The first periodic charge will be on the 10th anniversary of the pension member’s death.
We suggest it is best to set up the bypass trust on the same day as your pension fund is established.
The current nil rate band for Inheritance Tax is £325,000. Assuming the pension scheme member (i.e. policyholder) had not made any financial gifts in the previous 7 years then the trust might be able to use the nil rate band at the time.
Any excess would be subject to the periodic charge. This is calculated as 30% of the amount payable for chargeable lifetime transfers, which is 20%. 30% x 20% = 6% and that is the current periodic charge.
When payments are made to beneficiaries by the trust there will be an exit charge. This is a pro rata 6% since the last periodic charge was levied.
Drawdown and Spousal Bypass Trust
One important point to note is where your pension is in Drawdown, in a number of little policy “clusters” and some of your pension fund has been crystallised (drawn funds from) and some not i.e. you are in phased drawdown.
In the event of death, any crystallised pension fund paid out as a lump sum use to be taxed at 55%, but under new flexible drawdown rules, the beneficiaries will not be ttaxed if you die before age 75 and taxed at their normal income tax rates if you die after age 75. This would happen even if the fund was put in the bypass trust.
Alternatively, your spouse could continue with that portion of the fund in Drawdown and the 55% tax charge would not be suffered.
For the uncrystallised pension funds, they can pass into the trust without the charge under current legislation, although this could change.
Many pension providers offer both a bypass trust and letter of wishes covering this eventuality, so that your partner may continue with Drawdown for the crystallised part and the non- crystallised part can transfer to the bypass trust.
Spousal Bypass Trust Advice
The above can be an effective way to plan your estate if you have considerable wealth or indeed if you do not but today, but you and you partner will potentially inherit or accrue other wealth taking you over the inheritance tax allowance threshold. The need for professional pension advice is important and we suggest you contact us for advice on pension and estate planning.