Should you consider a spousal bypass trust for your pension?

The death benefits of a pension fund can in most cases be passed to loved ones, via an “expression of wishes” form. Under the flexi access pension rules, funds passed to a spouse will pass tax- free (note that income tax is payable at the beneficiaries marginal rate after age 75). However if you leave the pension fund to your spouse, this means that when they die, those funds will form part of your partner’s estate on their death and would then be subject to inheritance tax.  Spousal Bypass trusts can help to mitigate this and play a useful role in IHT planning.

The use of a Spousal Bypass Trust effectively “by passes” a beneficiary and instead the funds are passed to a family trust. This type of trust is particularly suitable for High Net Worth individuals and their spouse or civil partner

A bypass trust is an irrevocable discretionary family trust. It is established during the lifetime of the member or in their will and the trust will stay dormant until the member’s death.

The member/pension holder appoints and instructs the trustees of the Spousal Bypass Trust on how they wish them to distribute any funds the trust may ultimately receive on death. However, it is important to note that although the member appoints and instructs the trustees, the actual distribution will be at the trustees discretion and as such they may choose not follow the member’s instructions. So you should choose your trustees carefully. Your surviving spouse can still benefit from income, capital and loans from the trust at the discretion of the trustees. The only difference is that the money is not inside your partner’s estate for Inheritance Tax purposes.

Why would you choose to set up a spousal bypass trust?

It may be that some member/pension holder’s prefer to have a greater degree of control in relation to their pension funds.Another reason for setting up a spousal bypass trust could be access. For example if the member wishes to keep the funds away from the direct access of a beneficiary.Asset protection could be another reason: The trust can help to protect assets in the event of the beneciaries divorce or bankruptcy.

Spousal bypass trusts can also be used to hold assets for the benefit of children or grandchildren who cant manage their own affairs.

The benefit of using a spousal bypass trust can allow the spouse to take interest free ‘loans’ from the trust rather than receiving discretionary payments.  This works best when the spouse requires income from the trust and spends the loan creating a debt against the estate repayable on death, which further reduces the size of the estate and IHT due.

By creating a bypass trust solely in conjunction with their pension benefits, the member may benefit from a full nil rate band for this trust.

The trust will be subject to its own IHT regime, currently a charge every 10 years of 6% and an exit charge. It is important to note that the 10-year periodic charge cycle begins at the point the member joins the scheme, even where the bypass trust was established at a later date.The members pension lump sum death benefit where death occurs pre age 75, will be paid tax free to the trust. However the issue becomes more interesting when the member was aged over 75 at the time of their death. In this instance, the scheme administrator must first deduct the special lump sum death benefit charge of 45 per cent before paying the pension funds to the trust. However, this amount is not “lost” to HM Revenue & Customs forever. When a distribution is later made to a beneficiary of the trust a tax credit is attached to it for the amount of tax already paid.

The lump sum settlement from a pension fund to the Bypass Trust has to be made within two years of the death of the member, otherwise IHT is payable. If at the end of the two years the trustees decide that the trust is no longer suitable for the circumstances of the beneficiaries, then they can wind up the trust and distribute the assets before the two-year tax-free period expires. 

Spousal Bypass trusts are realtively easy to set up and most pension and life assurance companies offer documentation to form them.

Given today’s complicated family structures, and the possible financial irresponsibility of potential beneficiaries, there will always be situations where spousal bypass trusts constitute the most appropriate destination for a lump sum death benefit from a pension.