Andy Zanelli highlights the top 10 questions about pensions and trusts
1. What type of trust would you use with regards to a pension lump sum?
In order to retain favourable inheritance tax treatment a pension trust will normally be discretionary in nature. However there are a couple of ways of using trusts in conjunction with pension lump sum death benefits. The first is by using an integrated trust and the second is by considering a pilot trust.
2. What is an integrated trust?
An integrated trust can be used where the terms of a registered pension scheme e.g. a personal pension scheme (fully insured or self-invested) allow a lump sum death benefit to be paid automatically to a trust established by an individual. An integrated trust would also be used for a registered pension scheme in the form of a ‘section 32' contract, or a retirement annuity contract.
3. What is a pilot trust?
A pilot trust can be used where the member's pension scheme rules do not contain a provision that allows for a lump sum death benefit to be paid automatically to an integrated trust, for example an occupational scheme. In these circumstances it is possible for a trust to be established by the member during their lifetime, typically for a nominal amount e.g. £10. The purpose of the trust is then to receive the pension lump sum death benefits payable at the discretion of the trustees or scheme administrator of the occupational scheme in the event of the member's death.
4. What is the perpetuity period of a pension trust?
This is a tricky one and will depend upon a number of factors. In law the trust property must be used for the beneficiaries within a prescribed period of time. If you are dealing with an integrated trust established on or after 6 April 2010 the perpetuity period is 125 years. For a pilot trust the perpetuity period will again be 125 years on the basis that the pension scheme was established after 6 April 2010, the individual joined the scheme on or after 6 April 2010 and the pilot trust was established on or after 6 April 2010. There are myriad other permutations which will have an effect on a trust's perpetuity period, my advice is to find a very dark room and a couple of strong painkillers!
5. Could a pension lump sum death benefit be made subject to inheritance tax (IHT)?
Under a registered pension scheme in the form of a personal pension scheme or an occupational pension scheme, normally no inheritance tax would apply to a pension lump sum death benefit. Under a registered pension scheme in the form of a ‘section 32' contract or retirement annuity contract, the lump sum would be paid to the individual's estate (assuming an integrated trust has not been set up) and would therefore clearly form part of the estate for inheritance tax purposes.
The lump sum must be paid from a registered pension scheme within a ‘two year window', which begins with the earlier of either the day on which the member's death was first known to the scheme administrator or trustees, or the day on which the scheme administrator or trustees could first be reasonably be expected to have known.
The two year window continues where payment is made from the scheme to an integrated trust. This means that where the trustees of the integrated trust pay out the money within that window, there will be no exit charge or periodic charge if one would have arisen while the money was held within the trust.
The two year window does not continue if the lump sum death benefit goes into a pilot trust.
6. What happens if the trustees of an integrated trust do not pay out the trust fund inside this two year window?
As we are dealing with a discretionary trust where the trust fund is not wholly disposed by the trustees in the two year period as discussed above, then the usual periodic and exit charges will apply. The due dates for the periodic charges following the member's death will generally be on each 10 year anniversary of the date the individual joined the original pension scheme. (S81(1) Inheritance Tax Act (IHTA) 1984).
7. What would be the amount of inheritance tax payable?
The calculation is complex but in general terms the periodic charge will not exceed 6% of the value of the trust fund. If the trust fund is not disposed of by the trustees in the relevant two year period when any property leaves the trust, it will be subject to a proportionate charge based on an appropriate fraction of the ‘effective rate'. Again this generally would not exceed 6% due to the proportionate charge being based on the previous anniversary charge.
8. In what circumstances could inheritance tax apply to lump sum death benefits?
This is a tricky area of law, but a good example of where an inheritance tax charge may come into play is where an individual sets up an integrated trust for their pension death benefits. In these circumstances a transfer of value will be deemed to have occurred under s3(1) IHTA 1984*. Where the individual is in good health the transfer of value is deemed to be nominal. However, if the member was not in good health and/or dies within two years of making such a transfer then the deceased member's personal representatives will need to complete the relevant section in the IHT 409** and report to HMRC. Advisers need to be careful in placing a retirement annuity, section 32 or, depending upon circumstances the death benefits of a personal pension, into trust where health and life expectancy of a client is an issue.
9. Are there any more examples?
Be careful with pension transfers where ill-health is an issue. HM Revenues & Customs (HMRC) takes the view that, where an individual has surrendered their rights under their existing pension plan and effected a transfer, there is a loss to the estate if the new arrangements for the payment of the lump sum death benefits are not in favour of the estate. HMRC takes no account of the way the receiving scheme actually deals with death benefits - it is assumed that there would be an option to direct payment to the estate. Again, we are looking at a transfer of value under S3(1) IHTA 1984 which, as above, would need to be reported in the IHT 409 if the individual was to die within two years of the transfer. The moral of the story is to be very careful with any pension transfer for any client that is in ill health as the IHT consequences may be serious.
10. Is it possible to place protected rights funds under trust?
Simply put, yes. This can provide a solution to an IHT problem that would otherwise arise for protected rights.
A protected rights fund will be paid as a lump sum where there is no surviving spouse or civil partner. The legislation around protected rights specifies that the lump sum must be paid in accordance with any direction given by the member to the scheme administrator in writing, or, if the member has not left written directions, to the member's estate.
If no directions have been left, the lump sum will clearly form part of the estate for IHT purposes.
Where the member has left written directions, the IHT situation depends on whether the direction is 'revocable' or 'irrevocable'. 'Revocable' means that the member is able to change the direction at any time during his or her lifetime. A direction will be 'revocable' unless it is specifically stated to be 'irrevocable', in which case it cannot subsequently be changed. Where the direction is 'revocable', the value of the lump sum will be added to the estate for IHT purposes. This is on the basis that the member could have revoked the direction right up to the point of death, in which case it would have been paid to the estate. If the direction is 'irrevocable', the value of the lump sum will only be included in the estate for IHT purposes if death occurs within two years and the member was in ill health when the ‘irrevocable' direction was made. The member can create an ‘irrevocable' direction by setting up an integrated trust for the scheme under which a protected rights lump sum death benefit would be paid.
Andy Zanelli is head of technical sales at AXA Wealth
* IHTA 1984: Inheritance Taxes Act 1984
** Inheritance tax 409 is an Inheritance Account form
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