When is using a bypass trust still appropriate? Lisa Webster, senior technical consultant at AJ Bell looks at when it is an option for paraplanners to use.
When the new death benefit rules were introduced as part of pension freedoms back in 2015 the appeal of discretionary bypass trusts, or spousal bypass trusts, appeared to be significantly reduced.
Prior to the rule change only dependants could take income following the death of a pension scheme member, anyone else could only take benefits as a lump sum. Now anyone nominated by the member is eligible to take beneficiary’s drawdown and keep the funds in a pension wrapper until they need them. From a tax point of view this is very attractive – tax-free growth, and if the member died before age 75 the beneficiary can take income tax-free when they need it. Even if the member died after 75 keeping funds in the pension allows the beneficiary to manage their withdrawals each year to minimise the tax they pay.
There’s also the bonus that if there are funds left when the beneficiary dies the funds can be passed on again – and still remain within a tax-free pension wrapper. What’s more, even if the original member died over the age of 75 (so any income the beneficiary took was taxed), if the beneficiary then dies before 75 any income taken by the next beneficiary will be tax free.
The ability to cascade wealth down generations outside of the estate in such a tax-efficient way is very attractive.
So why consider a bypass trust?
The main issue with passing on funds within pensions is the lack of control for the original member who built up the pot. They get to nominate as to who they want to receive the funds on their death, but they cannot control how that beneficiary takes the funds, or what they do with them on their own death.
In many families this will not be issue – member nominates spouse or partner, who takes an income, and if there’s anything left leaves it to their children.
It gets more complicated when there are second marriages and children of one partner but not the other. So the member may leave funds to their (second) spouse but would like the funds on their death to go to the children from their first marriage. For this to happen the second spouse would have to nominate children that aren’t theirs – which they may or may not want to do if they have children of their own. If the survivor re-marries then this can also lead to funds being diverted away from the original members’ descendants.
The other issue is how funds are taken. We have been asked on a number of occasions if the member can stipulate that the beneficiary can only access the funds as an income, and not take it all in one go. This simply isn’t possible within a pension. Once the scheme administrator has decided who the benefit recipients are, they will always have the option of taking the whole fund as a lump sum. If they are nominated or a dependant they will also have the option of leaving funds in the pension with unrestricted access.
They are occasions where the member may want to provide for a beneficiary but, for whatever reason, don’t want them to have access to the whole amount as a lump sum.
A bypass trust can help in these situations. The member can nominate the trust to receive their pension as a lump payment on their death. They get to choose the trustees and can give them clear instructions which are more nuanced than pensions allow. For example, they can provide for a spouse in their lifetime then any residual funds go to children from a previous marriage or provide for vulnerable beneficiaries without them having access to the whole sum.
Tax position
Where the member dies before age 75 there is no tax to pay when the pension death benefits are paid to the bypass trust (subject to the lifetime allowance), and the standard trust tax charges that apply may be a small price for the desired control.
If the member died age 75 or over then the special lump sum death benefit charge of 45% applies on funds paid to the bypass trust. However, when a distribution is later made from the trust a tax credit is attached for the tax already paid.
There is no time limit for onward payment of the lump sum death benefit from the trust to the beneficiary (other than the perpetuity period which is usually 125 years). However, the longer the period the bigger the impact will be of the lost compound growth on the 45% paid to HMRC compared to funds remaining in the pension.
Whether it is a cost worth paying will be down to the individual.
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