Spousal bypass trusts can help in complex family situations, explains Clare Moffat, and are still highly relevant even after the introduction of the Taxation of Pensions Act 2014
Death benefits on pensions are usually not liable to inheritance tax (IHT) on the death of a member. Before April 2015, the main reason spousal bypass trusts were set up was so lump-sum death benefits did not become part of the IHT assessable estate of the intended beneficiaries.
New legislation introduced by the Taxation of Pensions Act 2014, however, means that, in the vast majority of cases, the benefits are now able to pass down through generations free of IHT - as long as they remain in the pension wrapper. As such, many have said that spousal bypass trusts are no longer required.
On the death of a pension member, the pension fund will usually pass to a dependant or nominee, nominated by the member. However, it is important to note that, on the subsequent death of the dependant or nominee, the funds retained within the dependant/nominee drawdown account, will pass to a successor of their choice, and this may result in the funds not following the original member's line of succession.
This can be an issue due to the rise in the number of ‘blended families', where there are children from different relationships. Without a spousal bypass trust in place, although the recipient of the pension fund may take the original member's wishes into account, they are not compelled to do this.
As an example, on inheriting a pension, if a spouse subsequently remarries, they may choose to nominate their new spouse to receive the pension benefits on their death. On inheriting these benefits, the new spouse may then choose to pass these funds on to their own children and ignore the original member's bloodline.
The benefits of a spousal bypass trust
A spousal bypass trust effectively 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 then control the destination of what was the pension fund money. This level of control is not offered under the pension freedom reforms, where the member's dependant or nominee will then nominate a successor via their own expression of wish form.
It is important to note, however, that although the member appoints and instructs the trustees of the spousal bypass trust, the distribution will be at the trustees' discretion and, as such, they may choose not to follow the member's instructions. Careful selection of trustees is therefore imperative.
There could be many reasons why the member wants more control over the destination of their pension benefits. In addition to a complex family situation, it could also be the case that the member does not think a beneficiary should be given the option of taking a cash lump sum and they would prefer a regular income to be paid.
Or perhaps the member is looking to the future and, if a spouse were to receive a dependant's drawdown and then ended up in long-term care, then the drawdown would be taken into consideration by the local authority. This would not happen if the money was in trust.
Another potential scenario is where the member wants an adult child to benefit, but they are concerned about the strength of the intended beneficiaries' marriage. Paying the funds direct to the beneficiary may result in any lump sum or drawdown being considered as matrimonial property on any subsequent divorce.
The taxation of a spousal bypass trust
A lump-sum death benefit paid from a pension scheme is taxed depending on the age of the member, whether they die before or after age 75. Prior to age 75, any lump sum death benefit is generally paid with no deduction of tax (subject to available Lifetime Allowance) where it is paid within two years of the scheme becoming aware of the member's death.
Post 75, where payment of lump-sum death benefits are paid to an individual, they are generally taxed at the marginal rate of the recipient - however, payments to spousal bypass trust will be subject to the 45% special lump sum death benefit tax charge.
After 6 April 2017, however, this 45% tax charge comes with a reclaimable tax credit if the benefits are ultimately paid to an individual beneficiary. This means the beneficiary will usually - subject to periodic and exit charges, and potentially the tax on the fund growth - end up in the same position as if they had received the money directly from the pension scheme and paid marginal rate tax.
Ultimately, if a client's main objective is to be able to influence the ultimate destination of the accumulated money ahead of the particular tax wrapper that it is held in, a spousal bypass trust could be a useful planning tool.
Clare Moffat is senior technical manager at Prudential
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