I have a significant amount of money invested in my Sipp and am concerned about the inheritance tax liability that my wife and children might have following my death. I have heard about something called a spousal bypass trust. Can you please explain to me how this trust works and whether it might be of some benefit to me?
A spousal bypass trust is a discretionary trust that is set up with the sole purpose of receiving the benefits of a pension scheme(s) on the death of the member. The benefit that you would get by setting up such a trust is that you would be minimising the charge to inheritance tax that might otherwise be payable on the death of your surviving spouse.
Under current pension legislation, any (discretionary) distribution by the trustees of a pension fund that has not been crystallised will not be chargeable to IHT, provided that the accumulated funds are distributed within two years from the date of death of the member.
It is quite common that such distributions are made to a surviving spouse/civil partner (who would normally have benefited from the spouse/civil partner exemption anyway) and then subsequently an IHT charge may arise on their death – when the property is eventually passed to the next generation.
Although they would benefit from their own nil-rate band (currently £325,000 for the tax year 2011/12), any sum over this amount would currently be taxable at a rate of 40 per cent.
The spousal bypass trust can help to minimise this eventual IHT charge while at the same time ensuring that your surviving spouse (or indeed other family members) may still be able to benefit under the trust.
The trust is set up as a discretionary trust with the potential beneficiaries, including your wife and children. This means that during your wife’s lifetime, she can benefit from income and capital distributions (and in some cases even from a loan of the trust property). However, the assets in the trust will never form part of her estate and will not therefore be taxed on her death.
It is even possible for the trust to continue after her death for the benefit of the next generation (however, the trust is flexible so that if she has need of all the trust fund, it can be distributed to her).
There will be a periodic charge to IHT on the bypass trust on each successive 10-year anniversary of the trust, starting from the date when the member established the Sipp.
However, while you are alive, there is no such charge levied as although the 10-year period is running, the tax charge is dormant during this time. Therefore, the initial 10-year anniversary which is taxable is the first 10-year anniversary falling after your death.
The trust may benefit from a nil-rate band (as noted above, this is currently £325,000). Thereafter, the charge to tax is 30 per cent of the rate of IHT which applies to lifetime gifts – currently 20 per cent – that is, a 6 per cent rate on the amount in excess of the nil-rate band. As such, this 6 per cent charge is the maximum charge that could be levied and will be less if the nil-rate band is applicable to the trust.
This 6 per cent maximum charge can often therefore be viewed as the annual “cost” for using the trust (it totals a maximum of 0.6 per cent a year).
In addition, when the trust is eventually wound up or capital is distributed from the trust to a beneficiary, there is an exit charge – the 6 per cent tax charge is pro-rated over the period since the last anniversary charge.
Patrick Murphy is head of professional standards and adviser support at Bluefin Group