Case study: Spousal bypass trusts and pension benefits

The problem: One of my clients has queried whether he should be utilising a spousal bypass trust in respect of his pension plans. What are the main advantages and disadvantages? Are there any further considerations following the pension rule changes in April 2011?

The solution: A bypass trust is a discretionary trust set up by a member of a pension scheme to receive the lump sum death benefits from a pension plan.

Commonly the death benefits from a pension scheme are distributed to a surviving spouse and therefore an inheritance tax charge may occur on the death of the surviving spouse, when the assets are passed to the next generation. Spousal bypass trusts avoid death benefits passing directly to a spouse and so they will not form part of the spouse’s estate.

The trust can include the spouse as a potential beneficiary in case he or she needs access to the capital. It would be a more tax advantageous to include the ability for the trust to make interest free loans to the spouse. This creates a debt on their estate which would need to be repaid on death, further reducing the value of his or her estate for IHT purposes.

A bypass trust cannot be used with a Section 32 buyout plan or a retirement annuity contract.

It could be used very effectively in respect of lump sum death benefits from a death in service scheme, ensuring that these (often large) payments are outside of the spouse’s estate.

Together with the IHT advantages, a bypass trust will enable the pension holder to retain an element of control. They can provide a letter of guidance to the trustees outlining the preferred recipients of their death benefits.

A spousal bypass trust is likely to be more beneficial for uncrystallised funds than lump sum death benefits in respect of crystallised funds or post age 75 lump death benefits. This is as the latter two will be subject to a tax charge of 55 per cent.

Previously, crystallised funds were subject to a 35 per cent tax charge, and therefore for higher rate tax payers this could have been more advantageous than receiving an income and paying tax at 40 per cent. Now that the tax charge on lump sums has increased to 55 per cent, taking an income has become relatively more attractive.

If the client does enter into a capped drawdown arrangement, or post age 75, he can always provide a revised letter of wishes regarding his death benefits and state that his preference is no longer for the spousal by pass trust to receive the benefits on death.

In addition to the option to take the death benefit as a lump sum, the spouse has the option to purchase an annuity or continue in capped (or flexible) drawdown.

It is important that the client is in good health at the time the trust is set up. Putting pension death benefits into trust is a chargeable lifetime transfer for IHT purposes.

However, if the client is in reasonable health then the death benefits will only have a nominal value. If the client is in poor health and died within two years of establishing the trust the transfer could be assessed as having a significant value and therefore become liable for IHT on the transfer.

The trust will be subject to periodic and exit charges as per discretionary trusts. While the client is alive there will be no charge as the trust will have no value, unless the client was in poor health as described above.

The periodic charge is 30 per cent of the IHT rate applicable to lifetime gifts, which is current 20 per cent. This gives a maximum charge of 6 per cent and it will be less if the nil rate band is applicable to the trust.

In any event, you should introduce your client to a suitably qualified solicitor and work with them to establish the most appropriate trust structure.

Off-the-shelf trusts from product providers can be effective, but this is one area where specialist legal advice is recommended.

Shelley McCarthy is a senior paraplanner at Informed Choice