The concept of bypass trusts has been around for a long time based on the idea of leaving pension death benefits to your spouse without forming part of their estate. This allows full access to the funds without being impacted by inheritance tax (IHT). Over the years the use of bypass trusts has been highlighted in various ways with different ‘USPs’ (unique selling points) such as the benefits of trust based pensions compared to contract based pensions and the use of multiple trusts set up on consecutive days. Variations on these discussions have taken place over the years but the one thing in common that everyone agreed on was that bypass trusts were a good option for generational planning.
Since the publication of the Taxation of Pensions Act however, opinions appear to be split.
There appear to be many people now saying that due to the death benefits from drawdown contracts being available tax-free if death occurs before age 75, bypass trusts are no longer relevant. The argument is generally that you can now leave all benefits to whoever you want and they will be tax free either in a lump sum or income - all very true, especially if income payments are chosen, which can then potentially be passed on inter-generationally.
However, a bypass trust is more than a vehicle for pension planning – it provides different options for the tax-free lump sum payments to be made which will not form part of the recipient’s estate. An example could be placing the lump sum in trust with provision that payments should be made on specific events – instead of held outright.
The trust gives flexibility to amend who is actually going to get the money at any time. Direct payment to a beneficiary is permanent and would form part of their estate. This would mean that should they wish to pass the money on, it would become a potentially exempt transfer from them to the recipient.
As lump sums will now be 55% larger (i.e. without the tax charge on the crystallised lump sum before age 75) they will cause potential issues for beneficiaries’ estates. It is these cases where the bypass trust needs to be considered as an option rather than giving funds directly to an individual and creating an IHT issue.
For example if a pension valued at £500,000 is left to a wife on the death of her husband and taken as a lump sum, this will form part of her estate for IHT purposes. If she decides to give some of the lump sum away to their children, this will be regarded as a PET and still part of the wife’s estate on her death within seven years (i.e. the full £500,000 still forms part of her estate on death). Assuming the husband’s nil rate IHT band (NRB) has been fully utilised and she has used up all of her nil rate band, if the value of the estate is over the NRB (currently £325,000), there will be a potential IHT charge of £200,000 (i.e. £500,000 x 40%).
Alternatively, upon the husband’s death the lump sum of £500,000 is left to a discretionary bypass trust. As it is coming from a registered pension scheme there is no entry charge into the trust. Payments can be distributed to the spouse or children, or any other beneficiary at any time in the first 10 years with no exit charges applied. However, there will be a periodic charge that will be liable on the 10th anniversary which is equivalent to 6% of the excess fund value over the nil rate band (6% of £175,000 = £10,500).
It should be noted that by-pass trusts can also accept benefits on death after age 75. However, these payments will be subject to the trustees rate of income tax.
There is no right or wrong answer to whether you should use a bypass trust. However, having all available planning options at the point of death means prudent financial planning.