The current death benefit rules for pension schemes are very generous and allow great flexibility in terms of distribution.
Providing appropriate nominations are in place, benefits can be passed on within a tax-advantaged pension environment for generations. In many cases withdrawal will be tax-free for the beneficiary and, at worst, taxed as income when paid to an individual.
Given these flexibilities, why would anyone want to use a bypass trust?
Bypass trusts are discretionary trusts and, as such, the usual periodic and exit charges will apply in addition to income tax and capital gains tax. In a pension, the investments are tax-free.
The answer can be summed up in one word: control.
It is not uncommon for a pension scheme member to want to make provision for a spouse or dependant for their lifetime, then want any remaining funds to be passed on in a certain way on their subsequent death.
For example, Mr A is on his second marriage and wants his spouse (Mrs A the second) to be looked after but on her death for funds to go to his children from his marriage with Mrs A the first. There is no way this can be catered for within a pension. On Mr A’s death the funds would go to Mrs A the second (if that was the decision made by the scheme administrator) but on her death the scheme administrator would only need to look at her wishes, not those of Mr A.
The other question we get asked is whether scheme administrators can place restrictions on how benefits are taken. This is most commonly in relation to young adult beneficiaries (those in their late teens or early twenties), where the member wants to make provision for them but not for them to have access to the whole fund.
This simply is not possible under a pension. For under 18s the parent or legal guardian will control access but once the child hits 18 it is theirs to do with as they wish.
A bypass trust can be useful in these situations as the member can appoint their own trustees and give clear instructions as to how they want funds distributed on their death and beyond.
Where the member dies before age 75 there is no tax due when the pension death benefits are paid to the trustees of the bypass trust (subject to the lifetime allowance) and the trust tax charges may be a small price for the desired control.
The issue becomes more interesting when the member was over 75 at the time of their death. In these instances, the scheme administrator must first deduct the special lump sum death benefit charge of 45 per cent before paying the pension funds to the trust. However, this amount is not “lost” to HM Revenue & Customs forever. When a distribution is later made to a beneficiary of the trust a tax credit is attached to it for the amount of tax already paid.
As an example, Mr Lee dies aged 76 with a Sipp worth £300,000 which is paid to a bypass trust. The trustees will receive £165,000 with £135,000 going to HMRC.
Later, a distribution is made to two beneficiaries for £35,000 each. No income tax is payable on the distributions and the beneficiaries each get a tax credit for the 45 per cent tax already paid. Effectively, these payments are treated as each beneficiary receiving £63,636.36 with tax paid at 45 per cent – so the tax credit is worth £28,636.36. This tax credit can then be used to offset their income tax liability for the tax year.
For those with an income tax bill higher than the credit, the whole credit will be used and the issue of the 45 per cent tax on funds going from the pension to the bypass trust is effectively neutralised. If the beneficiary does not have sufficient income in the tax year to have a tax bill of more than the credit, then HMRC have now confirmed that the difference can be reclaimed.
In practice, then, bypass trusts can still be just as appropriate as prior to pension freedoms.
Lisa Webster is technical resources consultant at AJ Bell