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Spousal bypass trust: the facts

The Technical Team at Prudential look at what spousal bypass trusts are, why they might be used and the tax implications of using them.

Key points

  • Spousal bypass trusts are still an effective planning tool
  • The desire for control when passing on death benefits will dictate whether a spousal bypass trust is set up
  • Death after 75 doesn’t mean that a spousal bypass trust is no longer relevant.
  • It is the government’s intention that from a tax perspective the new rules mean that the position would be broadly the same for the beneficiary of a bypass trust, as those receiving benefits directly from the pension.

Why are spousal bypass trusts used?

As mentioned in our Inheritance Tax and Pensions article on PruAdviser,  death benefits are usually not liable to inheritance Tax on the death of a member/pension holder. The main reason that spousal bypass trusts were set up before April 2015 was to receive the payment of lump sum death benefits so that they did not become part of the inheritance tax assessable estate of the intended beneficiaries.

However, new legislation introduced by the Taxation of Pensions Act 2014 meant that, in the vast majority of cases, the benefits are able to pass down through generations free of inheritance tax if they remain in the pension wrapper. As such many have said that spousal by-pass trusts are no longer required. However, it’s important to note that the on the death of the dependant/nominee, the funds usually pass to the successor nominated by the dependant/nominee, and not the original member/pension holder’s line of succession.

It may be that some members/pension holder’s prefer to have a greater degree of control in relation to their pension funds. With the increase of blended families this may mean that although the recipient of the pension fund may take the original member’s wishes into account, they are not compelled to do this.

On inheriting a pension, if a spouse remarries, they may nominate their new spouse to receive the pension benefits on their death. On inheriting, the new spouse may choose to pass these funds on to their own children and ignore the original member’s bloodline.

What is a spousal bypass trust?

This is usually called a “spousal by-pass trust”, although it should have just been called a “by-pass trust” as the recipient may not always have been a spouse. A spousal bypass trust is a discretionary trust which is set up by the member/pension holder to receive pension death benefits.

Most providers offer a template  spousal bypass trust (SBT) or a solicitor can draft one. It is usually established with £10. At the same time an expression of wish form is filled out which requests that any death benefits paid from the scheme / trustees are paid to that trust. The member/pension holder appoints and instructs the trustees of the SBT on how they wish them to distribute any funds the trust may ultimately receive on death.

On the death of the member/pension holder the scheme administrator must exercise their discretion but if an expression of wish form provides direction to do so they will usually pay to the SBT. The trustees of the SBT will usually then distribute the funds in line with the member’s instructions.

The trustees of the SBT could even issue the benefits in the form of a loan, which would be repayable from the estate of the recipient on their death, ensuring the availability of funds for future beneficiaries. The member could instruct the SBT trustee to pay sufficient funds to the member’s spouse during their lifetime (or earlier marriage) and thereafter to their children/grandchildren etc. This could be in the form of a regular income or ad hoc lump sums.

Before setting up a SBT it is important to check how the scheme distributes the death benefits. Some schemes may have no discretion on who they pay and may be obligated to pay to the member’s estate or a particular beneficiary. If this is the case they may not be able to accept any expression of wish in favour of a SBT.

If a member/pension holder changes their mind then they can rip up the expression of wish form which pointed to the SBT and fill in another expression of wish form.  The SBT will still exist but no death benefits will ever be payable to it.

Why set up a spousal bypass trust?

A SBT gives a degree of control over the ultimate destination of the monies accrued in a pension (as the trustees of the member’s trust will control the destination of what was the pension fund money). This is not offered by pensions freedoms, where the member’s dependant or nominee will then nominate a successor via their own expression of wish form.

However, it is important to note that although the member appoints and instructs the trustees of the SBT, the distribution will be at the trustees discretion and as such they may choose not follow the member’s instructions. Careful selection of trustees is imperative.

There may be many reasons why the member/pension holder wants more control.  As mentioned above, if the family situation is more complex then it could be to make sure that the pension money stays within the bloodline. It could also be due to the fact that the member doesn’t think that a beneficiary should be given the option of taking a cash lump sum and they would prefer a regular income to be paid. If a spouse received dependant’s drawdown and then ended up in long term care then the drawdown would be considered by the local authority.  This would not happen if the money was in trust.

It could also be because the member wants an adult child to benefit but they are concerned that the intended recipient’s marriage is rocky and that if a divorce happened then any lump sum or drawdown could be considered matrimonial property.

Taxation of spousal bypass trusts

A lump sum death benefit paid from a pension scheme is taxed depending on the age of the member when they die, with 75 being the “knife edge”.

Prior to age 75, it is generally paid with no deduction of tax (subject to available Lifetime Allowance) where it is paid within 2 years of the scheme becoming aware of the member’s death. Post 75, although payments to individuals are usually taxed at the recipient’s marginal tax rate, payments to non-individuals such as a SBT will be subject to the 45% special lump sum death benefit tax charge.

However, from 6 April 2016 this 45% may not be totally lost to the ultimate beneficiaries of the trust.

Section 206 (7) provides that a Lump Sum Death Benefit (LSDB) is not to be treated as income for any purposes of the Taxes Acts.

(a) it’s not income

(b) it’s not to be treated as income

So therefore it would seem that this money is lost to tax.

However, subsection (8) states that:

Where a LSDB is paid to a non-qualifying person* as trustee

and

that LSDB is distributed to an “individual” beneficiary

then

the amount received by the beneficiary (which will have suffered a 45% tax charge) and the tax charge is income of the beneficiary for tax purposes.

The 45% is therefore off-settable and the individual beneficiary may claim relief for the 45% tax.

* A non–qualifying person is defined as:

A person who is not an individual (a trust meets this definition)

Or

An individual who is acting in the capacity of a trust

(… and some others)

So (in the context of a SBT) a payment of LSDB to the trust then to a beneficiary is treated as income of that beneficiary, net of a reclaimable 45% tax credit.

Finance Act 2004, section 206 ( 7-10)

The administration process involved

Pension Schemes Newsletter 77 detailed that the pension scheme will have to inform the trustees of the gross value of the lump sum death benefit and the tax that has been deducted. The scheme administrators have to provide this within 30 days of making the payment to the trustees.

Further to this when the trustees then make a payment to a beneficiary from all (or part) of the lump sum death benefit received, they have to inform the beneficiary what proportionate gross value of the lump sum and tax paid from the pension scheme has been made to them. They must also provide this to the beneficiary within 30 days.

To reclaim any tax that may be due, the beneficiary will have to put this in their self-assessment tax return, which may lead to a refund in tax. If the individual doesn’t normally complete a tax return they can claim a refund using form R40.

Example of the taxation of a spousal bypass trust

A member has died post 75 and a lump sum death benefit payment of £45,000 is made to an individual with £52,000 adjusted net income.

Before any lump sum death benefits are paid the tax position of the individual is as follows:

Income Band* Tax Rate Tax due
£11,850 0% £0
£34,500 20% £6,700
£5,650 40% £2,260
Total £9,160

Ignoring the initial emergency tax that will be paid the income will be taxed as below:

Income Band* Tax Rate Tax due
£11,850 0% £0
£34,500 20% £6,900
£5,650 40% £2,260
£45,000 40% £18,000
Total £27,160

* Case studies use UK rates and allowances for 2018/19.

Scottish taxpayers will pay the Scottish rate of income tax (SRIT) on non-savings and non-dividend (NSND) income. NSND income includes employment income, profits from self-employment (including sole trades and partnerships), rental profits, and pension income (including the state pension).

Other tax and deductions such as Corporation Tax, dividends, savings income and National Insurance Contributions etc. will remain based on UK rules. For the 2018/2019 the rates and bands of tax relief now have significant differences to the UK rules.  This could mean the amount of income tax relief which can be claimed on pension contributions by Scottish and UK tax payers may not be the same. For more info on SRIT and how this works in practice, please view our Scottish Rate of Income Tax Facts page.

Therefore in this instance the recipient of the lump sum has had to pay £18,000 more in tax so the net benefit is £27,000.

If the lump sum were directed towards a trust the initial tax would be simple:

Income Band Tax Rate Tax due
£45,000 45% £20,250
Total £20,250

As per the above, the scheme would pay out £24,750 to the trust and the scheme administrators have 30 days to inform the trustees that there was a £45,000 gross value of the lump sum death benefit and that £20,250 tax had been paid.

If the trustees immediately paid £24,750 to a beneficiary, then this is paid with a tax credit of £20,250, so the total payment assessed against income tax is £45,000. At higher rate tax the liability on this would be deemed to be £18,000. As the tax credit is worth £20,250 there is actually an additional £2,250 that can be used to off-set tax paid by the individual. This effectively adds a further £2,250 to the net position of the £24,750. Which as per the money going to an individual gives the beneficiary a £27,000 net benefit.

SBT v cash lump sum

Although it looks like the eventual beneficiary will be in the same position if they had received a lump sum from the pension scheme directly or through a trust, there may be some differences. A SBT is a discretionary trust, and as such may be subject to IHT charges every 10 years (periodic charges), and exit charges when any money is distributed. In addition, once a lump sum is paid out of the scheme, the deduction of the 45% tax will limit any profit/loss from the pension fund, as less will be invested and it may not be as tax efficient.

Periodic and exit charges may apply to a spousal bypass trust.

When should a SBT be used?

Whichever route to cascade wealth through the generations is taken this should be thoroughly discussed with existing and new clients alike. But if a client’s main objective is to be able to influence the ultimate destination of the accumulated money over the wrapper that it’s held in, a SBT is a useful planning tool.

For information around life event topics such as marriage and intergenerational planning, take a look at Prudential’s Life Events hub.

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