When you make death benefit nominations on your pension, you are indicating to the pension that you wish your nominees to receive your pension outright in the event of your death. In many situations, this way of passing pension benefits on is entirely suitable, however where there are more complex situations it may be useful to deploy the use of a Bypass Trust which provides an enhanced level of control and flexibility over the distribution of your pension on death, whilst maintaining some important tax advantages associated with pension death benefits.
Bypass Trusts can be useful in a number of scenarios, the major ones being:
Where the pension member has a complicated family situation. When you nominate someone to be a beneficiary of your pension, on your death they would have an outright entitlement to the death benefits and, on their subsequent death, would be able to nominate whoever they chose, even if this would not have been in line with the original members wishes
Scenario: Jill was previously married to Oliver, with whom she had two children. They subsequently divorced and Jill subsequently married Ben, though Ben had no relationship with Jill’s two (now adult) children. Because Ben had nominated Jill to receive his pension death benefits, Jill would be free to pass on the remaining benefits on her death to whomever she chose, including her children, which Ben would not have intended. If a Bypass Trust was used, Ben could tell the trustees that Jill is to be allowed access to trust monies during her lifetime and that, on her death, any remaining capital was to be distributed in line with Ben’s further wishes.
Where there are young or vulnerable beneficiaries. It may be that you want to leave your pension death benefits to someone who may not be in an appropriate position to receive full access to the benefits. This could be due to factors such as age, health and lifestyle.
Scenario: Charlie is recently widowed, making him the sole parent of his daughter who has autism and doesn’t understand the value of money. He would like to leave his pension to her in the event of his death, however if he were to simply make a death benefit nomination in her name, she would have an immediate entitlement to all the pension monies when Charlie died. Charlie is concerned that if this were to happen, his daughter would simply give the monies away and/or spend them irresponsibly. If a Bypass Trust was used, Charlie could tell the trustees, for example, to pay his daughter a monthly allowance from the trust, in addition to lumpsum payments as and when required, but at the discretion of the trustees.
Where the use of loans to beneficiaries is important in their financial planning. If the intended beneficiary already has a substantial estate, drawing further funds from an inherited pension would increase her estate further, leading to a potentially higher Inheritance Tax charge on second death.
Scenario: Elliot and Rebecca were a wealthy married couple and on Elliot’s death, Rebecca received all of his estate in addition to his pension. The value of Rebecca’s estate is now at such a level that it is c.£200,000 over her available Nil Rate Bands (NRBs) and Rebecca’s executors will therefore have to pay Inheritance Tax on this amount in the event of her death. If Elliot had set up a Bypass Trust for his pension, the trust could loan Rebecca £400,000 (to cover the current excess over her NRBs, plus allowing for further growth in the value of her estate) which she could spend however she wishes and, on her death the outstanding loan would be debt on her estate – reducing its value by £400,000. If the loan was fully spent, the net position would likely bring her estate within her available NRBs meaning there would be no inheritance tax to pay on Rebecca’s death.
Bypass Trusts also have special tax rules to bring them broadly in line with normal pension death benefit taxation:
The similarities to pensions are as follows:
- There is no inheritance tax to pay on death
- The pension benefits pass free of income tax into the trust if the member dies before age 75, and are subject to income tax on entry to the trust if the member dies after age 75
However there are some significant differences:
- The income tax charge in the event the pension member dies after age 75 is at 45%, meaning only 55% of the pension actually remains in the trust to grow. In this event, when trust monies are paid out to beneficiaries, they carry a 45% tax credit and the beneficiary only pays income tax at their marginal rate
- Periodic and exit charges apply in the same way they do for a normal discretionary trust
- Income and capital gains within the trust are subject to income tax and capital gains tax in the normal way for a discretionary trust
- The administration and cost associated with maintaining a trust
There is clearly a place for Bypass Trusts in the arena of financial planning, however it would only be suitable where an enhanced level of control and flexibility is needed that cannot be satisfied by making normal death benefit nominations.
The content of this article is for information only and does not constitute formal financial advice. This material is for general information only and does not constitute investment, tax, legal or other forms of advice.
You should not rely on this information to make, or refrain from making any decisions. Always obtain independent, professional advice for your own particular situation.
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