This basic guide lays out some key fundamental information that will need to be understood for the use of spousal by-pass trusts with different types of pension scheme structure.
Please note that this is a basic guide and not comprehensive. More detailed information is available in other specific Knowledge Direct articles.
This is a discretionary trust into which death benefits are paid rather than be paid directly to a spouse or dependent. In this way the pension fund should never form part of a dependents estate for IHT purposes although they will still have potential use of the fund.
A man dies leaving £600,000 of uncrystallised pension fund to his wife. She takes the fund and 2 years later dies herself. This means that the value of her estate has been increased by £600,000 and this will create an IHT liability, or;
A man dies leaving £600,000 of uncrystallised pension fund to a spousal by-pass trust and not directly to his wife. His wife is a potential beneficiary of the trust and so can benefit from the monies. When the spouse dies 2 years later this fund does not form part of her estate and so there is no IHT liability.
A by-pass trust is a stand-alone trust designed to accept pension fund death benefits and is not directly wrapped around a pension scheme. To get the monies paid into the by-pass trust the member will need to complete an expression of wish or a nomination form and present it to the pension scheme. This note will not be binding on the pension scheme but does give them an idea of where to make death benefit payments.
Discretionary Trusts and Taxation
A discretionary trust is liable to a series of tax charges through their life based on excesses over the inheritance tax exemption threshold. When monies are settled into a discretionary trust they are tested against the settlor's available IHT nil rate band. If there is an excess over this band there will be a 20% entry charge levied on all monies over the available nil rate band figure. Any monies coming from a registered pension scheme are not subject to an entry charge. There are also 10 year periodic charges and exit charges. Again, these charges are tested against the available nil rate band at the time of the charge and any excess can be charged at a rate of up to 6% of the excess.
If an asset is moved from one discretionary trust to another discretionary trust the new trust will inherit the start date and associated periodic charge date from the original trust and maintain this for those specific assets. Essentially you end up with one trust but with 2 entry dates (creation dates) and 2 periodic charge dates relating to different assets held within the one trust, one for the old trust assets and one for the new trust assets.
This is only a very brief summary of discretionary trust taxation and you are strongly recommended to look at this subject in further detail by reading our article: IHT of trusts (post Finance Act 2006): 3.
Trusts and Pensions
Traditionally pension schemes were set up under a discretionary trust arrangement. These trusts have all the same attributes of a normal discretionary trust although when benefits are held in pension scheme these are ignored. Periodic charges, entry charges (creation dates) and exit charges are not considered when the benefits are within a pension scheme, but when the benefits are paid on death into another discretionary trust (by-pass trust) all the previously ignored trust mechanisms will come back into force.
A pension set up in 1998 should treat this as the creation date and have a periodic charge in 2008 but this is ignored as it is a pension scheme. However, if the client dies in 2017 and benefits are paid into a by-pass trust in 2018, the "inherited but previously ignored" periodic charge will come back into force and will be levied against the by-pass trust.
This means that trustees of the by-pass trust will need to be able to get and maintain records of all previous pension scheme start dates and monies paid in, to ensure that these can be allocated to the correct periodic charge date relating to those assets. If you can imagine that over a period of time many pension schemes, all under trust, could have been transferred into to one scheme, this will mean the trustees will have to be able to determine where each segment of money came from and trace it through all other contributions, switches and transfers to ensure they report the correct amounts against the correct periodic charge date. As you can imagine, this can be a very onerous and complex task for the majority of normal trustees.
If it is possible to track down all of the previous pension schemes and allocate the correct monies to the correct periodic charge dates, this means that the use of one by-pass trust may be possible. If the monies are allocated correctly it would be possible to hold much more than the IHT nil rate band in assets in one trust and never breach the limits, and have to pay periodic charge as each element is considered individually.
Contract based pensions
A few pensions, like the Collective Retirement Account (CRA) are contract based pension schemes rather than trust based pension schemes. These schemes operate in the same way as trust based pension schemes but are run by a scheme administrator rather than a trustee. They have the same death benefits available as trust based pension schemes and are covered by the same inheritance tax legislation (IHT Act 1084 section 151). However, as they do not have any trusts wrapped around them, there are no inherited creation dates or periodic and exit charge dates to consider. This means that the only dates the trustees need to consider are those used to set up the by-pass trust in the first place.
As there is now only one set of dates to consider for charges, it means that in many cases it is likely that the pension fund death benefits at the periodic charge date within the trust will be well in excess of the nil rate band. As we have seen under trust based pensions, this can possibly be catered for by the many different periodic charge dates relating to the different pension schemes - assuming the trustees are able to find, record and keep track of all the monies and relating original trust schemes – however, we know this can be very complex and time consuming.
As there are no other trusts to consider with a contract based scenario, it is possible to set up a series of trusts (e.g. Monday, Tuesday and Wednesday) and elect for the pension death benefits to be paid equally into all three schemes. As these are non-related trusts coming from a contract based pension scheme, this will mean they all have their own periodic charge dates and will not need to consider the other pension scheme trusts and their current values but rather only the historic value. This is the value of the original trust asset. For this reason these trusts are generally set up with a small asset such as a £5 note, book of stamps or a small bond. This is called the Rysaffe principle.
A client holding a CRA valued at £800,000 as uncrystallised monies dies on 1 June 2015.
He had previously set up a series of by-pass trusts on consecutive days (Monday, Tuesday and Wednesday) from 1 July to 3 July 2007 and submitted an expression of wish letter to Old Mutual Wealth, who are the pension scheme administrators, requesting they consider paying his pension lump sum death benefits in equal shares to these trusts.
Old Mutual Wealth, as scheme administrators, carry out his wishes and pay £266,666.66 into each one of the trusts.
As the monies came from a pension scheme there is no entry charge to worry about.
On 1, 2 and 3 July 2017 each by-pass trust will have a periodic charge calculation date (10 year anniversary from the date of setting up the trust). As each trust will be tested separately against the prevailing nil rate IHT band (currently £325,000) there will be no tax to pay.
Legislation was introduced in the Finance (No.2) Act designed to restrict the use of multiple trust arrangements to reduce the potential tax liabilities on periodic and exit charges. By distributing benefits to multiple trusts set up on different days each trust would have its own nil rate IHT band and therefore could at least in part mitigate some of the on-going charging structures.
To prevent this from happening legislation was introduced covering “same-day additions”. Essentially this was designed to ensure that if distributions were made to multiple trusts on the same day the whole of the funds would be taken into consideration for any on-going tax calculations for each trust and not just the proportion put into the specific trust.
This would have the effect of ensuring that any distributions made in this way on death would be caught, as death distributions are always treated as though they were made on the same day.
However, pension death benefits can be distributed in partial instalments over a period of time (all within 2 years from the date of death). If this is allowable under the specific pension scheme death benefit distribution rules, this would mean that these distributions would not be caught by the “same-day additions” rules as distributed on different days and when calculating the charges the trusts would only be complied to take into consideration the historic value calculations and not the total value of the distribution made to all the pension schemes.
When a contract based pension scheme and by-pass trust can be advantageous
A large single pension fund with no previous transfers in
In this case a trust based pension using a by-pass trust needs to remember that all of the pension fund will be taken into consideration at the same time irrespective of how many by-pass trusts are used. This will mean periodic charges on the total excess. Remember, this will include a periodic charge date for the asset used to set up the by-pass trust and one for the original pension scheme.
A contract based pension can use multiple by-pass trusts, and benefits paid into these will be considered separately and not together as for the trust based pension described above. There will still be multiple periodic charge dates on consecutive days but no periodic charge to pay. If before death, the pension fund grows you can simply set up another by-pass trust.
One big pension fund made up of many smaller funds transferred in
With a trust based pension scheme the trustees will need to be able to track and record every pension plan the client has ever had and be able to track all the funds though each transfer and switch from the start of the individual pension funds to each date of the future periodic charge dates.
If these funds were transferred into a contract based pension scheme, the same simple scenario as described for a large single pension contract would apply.
Multiple Trust based pension looking to pay benefits into a by-pass trust on death
Essentially this is the same scenario as one big pension fund made up of many smaller funds transferred in. The same rules and issues will apply with multiple creation and periodic charge dates having to be recorded and tracked by the by-pass trust trustees.
If these funds were transferred into a contract based pension scheme the same simple scenario as described for a large single pension contract would apply.
The use of a bond to set up the by-pass trust
Remember that to set up any trust you will need to have an asset (“property”) to create the trust with. Many providers suggest that for simplicity a £5 attached to the trust or even a first class stamp can be the property.
However, as the purpose of using a by-pass trust is generally to ensure that a spouse has access to pension death benefits without them forming part of the spouses estate, it may be worth viewing the trust property as part of the inheritance tax planning process. On this basis it may be worth considering investing a bond instead of a £5 note. The reason for this is that this “asset” would then be outside of the estate for IHT purposes after 7 years and so would all of the growth. This mean that the client is effectively estate planning at this point in time.
If the client invests £10,000 into a bond and then assigns this bond into a by-pass trust as the initial trust property, this will be seen as a chargeable lifetime transfer. This will still form part of the settlor’s estate for the next 7 years but will then fall out of their estate.
If you assume the bond grows on average at 5% per year and the client lives for another 15 years this bond would be worth £20,789 at the point of death.
Had this money and growth still been within the client's estate, there would have been a potential IHT liability of 40% which equates to £8,315.60.
By making this gift at the outset of the by-pass trust, the client has reduced the IHT liability on the estate. Of course this is only one example of many options the client may have for inheritance tax planning.